We all know that rates impact our ability to buy the house we want. However what we don’t often realize is how intertwined the price of our most treasured asset is with the supply and demand for capital that creates prevailing interest rates.
To put it in simplest terms: in the long run, your house is an undiversified bond investment.
As you know from investment 101, when prevailing rates go down, bond prices actually go up. Unfortunately the reverse is also true, when rates go up, bond prices go down. This isn’t a clever ruse put over on us by fixed income bond wizards, this relationship is a simple mathematical fact of asset pricing.
Housing and the broader category of real estate is the most heavily financed asset class in the world. A large portion of the financial services industry is purely dedicated to helping consumers to borrow against their future income to buy a large asset today. That way they don’t have to wait for retirement to become homeowners.
Just like the bonds which underpin the mortgage industry, your home loan transaction is a mini bond issuance. Your investor (mortgage bank) buys your bond issuance (home loan) for promises to pay back the principal with interest in the future (your payments).
It’s our obligation to make good on our debts and payback the money we borrowed, if we collectively don’t make enough money to payback the money we borrowed, then our investors suffer as well. Just imagine: Bear Sterns will need to be sold in a firesale, Lehman Brothers would probably go under, Merrill Lynch will need to sell themselves, the Central Bank will have to step in to prevent a global meltdown, cats and dogs living together, mass hysteria.
Oh wait, that all actually happened!
To put it another way the foundation of your home price is a squishy combination of market forces like monetary policy, economic activity, government debt loads—just to name a few—that all collectively interact to set prevailing interest rates.
Contrary to popular opinion housing finance is not local, it is not even really national anymore, it is truly becoming global. Increasingly impacted by global market forces.
Unlike most forms of bond issuance, the capital raised in mortgage issuance can only be spent on one thing: Houses.
You can’t take a 30 year loan out on your car, appliances, or your kids education. The mortgage, a form of captive financing, can only be spent on the roof over your head.
Conversely when companies issue debt, they can spend the money however they choose, new factories, new products, research and development, etc. Simply beat the cost of capital by investing in projects that return more then the cost you borrowed and voila we have diversified economic growth. Companies have the right to choose the highest and best uses of how to invest the borrowed dollars.
Much like when you purchased your last home, the amount you could afford was highly dependent on the prevailing interest rates (cost of finance, the coupon payments on your bond), the same is true for all the future buyers of your home. The amount they can spend will be highly dependent on financing costs at the time they purchase in the future.
The scenario has worked out quite well for those early bond issuers who conversely borrowed at the high priced financing (home loan) and bought the corresponding low price asset (house).
If we look back, interest rates have been on a structural decline since the 1980s hair bands ruled the concert circuit and MTV actually played music videos. Mortgage rates in the late 1980s were over 10% annualized interest.
Take for example a house in my beloved Bay Area, where a combination of economic growth and prohibitions against construction & property development had converged to take an ever increasing share of family’s wages to afford the 1950s middle class dream of the home ownership. Many times it’s actually the same home, with original 1950s finishes, it now just costs about 10x average family income vs 4x income in 50s. And needs some serious remodel work to boot, but I digress.
So lets look at Exhibit A: Property X is a rare find built new in 1991 and sold for $450k. At the time the new home buyer was faced with a truly punishing prevailing interest rate near 11%. After a standard 20% down, the payment for $360k of debt a 30 year fixed rate mortgage was a whopping $3,428 per month. A lot of money today and certainly a lot of money in 1991 unless you were fronting a grunge band.
Fast forward from that era, and home price shot off like a rocket, fueled by ever declining interest rates.
The blessing of refinancing allowed those early buyers (bond issuers) to refinance their debt at lower rates locking in the gains on home price appreciation. The new generation of home buyers, were able to afford ever increasing home prices not because they made more money but simply because the cost to borrow against their future earnings continually declined through the 1990s, 2000s, as well as the first few years of this decade.
Property X values skyrocket and doubled by the early part of 2000s clearing the market just shy of $1m. By the 2007 peak it would have cleared the market conservatively around $1.3m, roughly a triple or 300% price appreciation in a 16 year period.
Of course we know the story of what came next: prices dropped back to improve affordability and rates have continued to be driven lower to support asset prices. Today the house is just under $1m.
Oddly enough at prevailing interest rates with a 20% down payment, the monthly payment to purchase the home is almost the same about $3,600 dollars per month. So despite the roller coaster ride of house prices, the home’s intrinsic value (based on its fundamentals) is remarkably unchanged in a 20+ year period.
True, the headline home price has doubled since the time it was built, but over that same time period, financing costs have declined about 70%, enabling the home price appreciation.
Think of it like a 25 year ski run of downward trending interest rates. We’ve went through some moguls, some double black diamond sections, but all along the way the power of gravity has propelled interest rates lower and home prices higher and now we’re at the bottom of a very long run. Unfortunately there is no ski lift back up and the hike up the mountain will takes us longer than it did to get down.
Without some serious income growth, a multi decade bull run in house prices will not be repeated as rising rates will continually provide a headwind for the next generation of home buyers who simply won’t be able to afford to pay more for the house than we did.
My humble advice to prospective homeowners is to buy a house you will not need to sell. Buy and hold your Bond (I mean home) to maturity. Locking in once and a lifetime interest rate will have the most benefits if you’re not forced to sell your house to future buyers that may face interest rates twice as high as today.