When Do Interest Rates Hurt Real Estate Investing?

While some signs point to a slowdown in the real estate market, home price appreciation remains strong. (Getty Images)

After years of near zero interest rates, the Federal Reserve is raising its benchmark rate, currently at 1.9 percent. Like a ripple across a still pond, as the Fed rate goes so do other important interest rates. And several more increases are expected.

Arguably the most important interest rate is the U.S. the Fed funds rate, which is the interest rate that banks charge each other to borrow money on an overnight basis. It’s also the Federal Reserve’s tool for influencing monetary policy.

Fixed mortgage interest rates tend to travel in tandem with the 10-year Treasury bond rate, which is a barometer for expected inflation levels.

As mortgage rates increase, owning a home becomes more expensive and sales of homes typically decline. But, here’s where the projections get tricky. We know interest rates are rising and we recognize that historically increasing interest rates quell home sales and new home starts. But, can the historical data inform when the current residential real estate market will falter?

"Interest rates and their effect on home values is not a straightforward correlation," says Ryan Tharp, director of research at Transwestern in the Dallas/Fort Worth area of Texas.

Today, unlike in the past, the housing market cycle is impacted by the recent tax bill, its cap on the deductibility of mortgage interest, and high state and local property taxes in the coastal regions of the U.S.

Before we pull out the crystal ball, let’s examine at how the housing market fared during prior rising interest rate periods.

A history lesson. Since 1990, there have been six bouts of increasing rates as measured by at least a 1 percentage point increase from trough to peak, reports FreddieMac in a recent survey, although none of these periods started with interest rates as low as they’ve been recently. FreddieMac found that in almost all cases a mortgage rate increase accompanied reductions in mortgage originations, home sales and housing starts.

Unfortunately for prospective home buyers, during none of those periods did housing price appreciation stop, yet during 1993 to 1994 and 1996, the price increases were minor. And, bucking the downward real estate sales trend that accompanies rising rates, from 2003 to 2004, home sales managed to squeeze out a 2 percent increase.

Currently, despite rising interest rates, the 4.625 percent average 30-year mortgage rate is relatively low. There wasn’t any period with mortgage rates this low from 1990 through 2010.

Back to present day. There is a whiff of a slowdown in the real estate market now, but nothing catastrophic. Five of the first six months of 2018 saw lower sales than the same period in 2017, reports the National Association of Realtors. Yet, home price appreciation is strong, and the real estate market continues to hold up.

Sam Dunlap, director and senior portfolio manager of Angel Oak Capital Advisors in Atlanta, is bullish on the real estate landscape. With strong economic data, including high employment, relatively low mortgage rates and the huge millennial group in the prospective home buying cohort, he thinks the housing market is strong.

So does the National Association of Realtors. The NAR Housing Affordability Index, which measures whether a typical family earns enough income to qualify for a mortgage shows that in the first quarter of 2018, the typical American family earned 157.7 percent of the amount necessary to qualify for the median-priced house of $245,500. (The median family income is $74,779.)

Looking forward. Robert Frick, corporate economist with Navy Federal Credit Union in Vienna, Virginia, says rising interest rates may not be a factor in the housing market for years to come. Contributing to the projection of a stable housing market is the years of low housing inventory and increasing legislation.

"Builders are handcuffed by lack of labor, zoned land and by the growing price of materials, especially lumber," Frick says.

FreddieMac explores three potential housing market scenarios for the future, each tied to distinct changes in the mortgage rate. These scenarios explore when rising rates might tip the scales and hurt the residential real estate environment.

In the first case, should the mortgage rate fall 0.1 percent, sales could increase 5 percent and new home construction might rise 10 percent. With an average fixed mortgage increase of 1.46 percent, sales might fall 5 percent and new home starts could drop by 11 percent. In the worst-case scenario, should rates rise 2.38 percent, sales would decline by 14 percent with housing starts down by 32 percent.

Home buyers, waiting on the sidelines should consider purchasing a residence now. Dunlap reiterates that in most regions in the U.S., home "affordability is historically attractive." Yet, as with any financial decision, buying a house is a long-term commitment.

Finally, now is not the time to wait for interest rates to return to 4 percent. It’s unlikely that we’ll see sub-4 percent mortgage rates again for many years, Frick says.

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