Effect of rising interest rates on California housing prices (2014, apartments)

[iExtrapolate]

The projection I often hear in the financial news is that we are entering a rising interest rate environment; one in which we can expect it to be the case that mortgage rates will be increasing rather than decreasing.

The projection, nationally, is that house prices will continue to rise. I agree that, nationally, this may be the case, but I think it is reasonable to believe that, in some supply constrained markets, it may not.

In markets that are not supply constrained, prices are determined by the cost to build the house (the lot values are not significant) which rises with inflation.

In markets that are supply constrained (SoCal is included here), prices are determined by what people can afford to pay: incomes, interest rates, allowable debt-to-income ratios and scarcity. Prices can rise faster than incomes if the ratio of people to housing units is increasing.

What determines what people can afford is the monthly payment. If someone can only afford a 3500/month payment, that translates to a price of $770k at a 3.5% interest rate, $665k at 5%, $605k at 6% and $555k at 7%.

I understand that the relationship is not one-to-one, but there clearly is a relationship between house prices and interest rates and there clearly is an interest rate number that would cause house prices to fall. Does anyone have a good idea as to what this would be?

Disclaimer: lower housing prices coupled with higher interest rates could make housing more expensive for those needing loans to buy them.

[brown_dog_us]

A couple of things:

1. When interest rates rise home owners will not move because it's too expensive. This will decrease turnover.

2. The main reason interest rates are rising is because wages are rising.

3. Interest rates also heavily impact residential construction costs. It's hard to develop a neighborhood, build the houses, and carry a high interest note for 10 years. New apartments would have a loan with high interest also. Basically, new supply is very limited as interest rates rise.

The impact of the rise in interest rates will be minimal if it happens slowly and is coupled with wage increases. A dramatic increase like doubling in 1-2 years will cause stagnation where nobody moves or builds.

[brown_dog_us]

One thing I omitted is nobody knows the impact of the new home interest deduction changes in regards to higher interest rates. What happens when mortgage rates are 8% in an expensive market like Southern California and the interest deduction is capped?

[iExtrapolate]

I think historically it has been the case that mortgage interest rates rose when wages rose cancelling out the depressing impact that they would have on housing prices.

In this case, mortgage rates were artificially depressed by the fed buying up trillions of dollars in bonds. As the fed sells these off, the mortgage rates will be pushed up by something other than rising wages.

If the mortgage rate climbs from 3.5% to 7%, that would increase the costs by 30% which would exceed any raises I think.

Good point about the deduction. That becomes more important as interest rates rise.

[iExtrapolate]

A 3.5% to 7% interest rate increase would also increase costs by 30% for those who took out ARM mortgages who might then foreclose.

[CA4Now]

Originally Posted by iExtrapolate

A 3.5% to 7% interest rate increase would also increase costs by 30% for those who took out ARM mortgages who might then foreclose.

While it's doubtful interest rates will go above 5% by the end of the year, anyone with an ARM needs to refinance now.

I didn't realize they even had ARMs after the last housing crisis.

[iExtrapolate]

From 2014: Adjustable Rate Mortgages Gain in Popularity Against Rising Prices and Mortgage Rates – Finance Post

In November 2014, 11.2% of homes were purchased with an ARM. I would expect the number to be higher now given the prices are higher relative to incomes.

[BB_210]

Probably flippers with those arm loans.

[Electrician4you]

Originally Posted by brown_dog_us

One thing I omitted is nobody knows the impact of the new home interest deduction changes in regards to higher interest rates. What happens when mortgage rates are 8% in an expensive market like Southern California and the interest deduction is capped?

People adjust. They come up with more down, pay extra on the principal, he’ll they may be able to do a dual loan mortgage to split the principal coming under the cap if it’s allowed, and sellers may have to drop the prices.
,

[iExtrapolate]

You say that people adjust. That is true. However, there is a limit to how much they can adjust. For example, if interest rates were 20% could the average family find a way to buy a $750k house? of course not! Nor could they at 7% either!

What I mean to say is that, while it is clear that an increase in interest rate from 4.0 to 4.2% will not crash housing prices, it is clear that there is some interest rate that will. So, if we are looking at this quantitatively, what interest rate would this be that would cause "sellers to drop the prices"?

That's the question. There is a number where buyers cannot adjust and, given how stretched the typical buyer is, I don't think the increase necessary to decrease housing prices is unattainable.