Interest Rates: Why the Sky Isn’t Falling
August 31, 2010The Hidden Value in Rental Properties When Rates Are Low
September 14, 2010I have always enjoyed challenging widely held beliefs, probably because so many of them fall apart upon closer examination. Most recently, my contrarian radar started going off in the summer as talk of a Canadian housing bubble increased from a simmer to a boil. One of the most common justifications used in the argument that our house prices are due for a
precipitous fall is that rock bottom interest rates have nowhere to go but up. When rates increase, the argument goes, affordability decreases and prices have to fall or buyers will be priced out of the market. Fair enough. It’s true that when interest rates increase, the cost of borrowing becomes more expensive, and it’s reasonable to assume that our historically low interest rates are more likely to increase than decrease over time. Bubble talkers regularly cite both factors when making their case, and after much repetition, consumers accept the conclusions that are drawn from these assumptions as valid. Far be it for me to let real data get in the way of a good round of group think, but alas, I do enjoy tipping over the apple cart, so here goes.
Over the past thirty years, increases in Canadian mortgage rates have not tended to trigger a decrease in houses prices. In fact, more often than not the reverse is true. Before I get into the numbers, let me start by citing my sources. I took the average five-year residential mortgage lending rate (from Statistics Canada) and compared it to the average selling price of a Canadian home (provided in a report by the Canadian Real Estate Association), on a month-by-month basis from January, 1980, up to June, 2010. I used the five-year fixed-mortgage rate because it is by far the most common term chosen by Canadians, and I went back to 1980 because that was as far back as the CREA stats went. The only tweak I made to the data was to compare interest rate changes to house prices two months hence, because I reasoned that higher rates would immediately impact offers to purchase, which take about two months to become transactions. Here is what I found:
Over this period, totaling 365 months, there were 156 instances where the five-year residential mortgage rate increased over the prior month, and in 97 of these cases, house prices increased two months later. That means that 
62% of the time, increasing mortgage rates corresponded with higher pricing. I also wondered what happened to average prices when rates rose precipitously, so I looked at cases where month-over-month rate increases were greater than 5% (this happened in only 22 of the 365 months observed). To my surprise, in 13 of those 22 months there was still an increase in average house prices two months hence. So, even in cases where rates rose dramatically, the odds were still better than 50% that they coincided with rising house prices. While I will concede that this ‘back-of-the-envelope’ analysis is a tad simplistic, I think a trend established using thirty years of data is compelling.
So how do we explain this counter-intuitive result? Well for starters, interest rates and house prices do not exist in a vacuum and both are influenced by the overall strength or weakness of our broader economy. Rising interest rates generally occur in a healthy economic environment where future price inflation is expected, making them a by-product of positive economic momentum. While it certainly is true that higher rates increase borrowing costs, this generally happens in periods with rising incomes, higher levels of employment and increasing consumer confidence. To take our contrarian thinking to its logical conclusion, we should all be rooting for higher interest rates. Seriously. Rock bottom rates are sustained when concern over inflation is replaced by fears of disinflation and outright deflation. Higher rates, on the other hand, are a sign of increasing confidence in our future economic prospects.
One last point. While I think the bubblers have misread the short-term relationship between rising interest rates and house prices, I am not altogether bullish about the immediate direction of house prices. We have seen substantial price appreciation in the last few years, and despite o
ur recent positive economic momentum, we are far from out of the woods. Our average income levels, arguably the most important predictors of the future of house prices, have not kept pace with the rising cost of real estate and the two measures must trend in the same direction over the long-term (with either prices falling or incomes rising to restore their equilibrium at some point). For that reason, I think house prices may well soften over the short-term, but not to a bubble-bursting degree. While the debate rages on, I hope that my analysis of the immediate relationship between rate increases and house prices gives you a different perspective when deciding which camp you’re in.
10 Comments
Right on! Over time, the housing market is a function of household formation, which in turn is a function of overall economic wellbeing. With unemployment rate hovering around 8% or more in Canada, we won’t see the kind appreciation of housing prices the last few years again any time soon. Bubble? There may be bubbles in isolated local markets like Vancouver and Victoria, for different supply and demand reasons, but I don’t think there will be a housing bubble across Canada. In any case, real estate bubbles are short term phenomena.
House prices are inextricably linked to interest rates – a couple of points that I think are missing in your analysis:
1) House prices probably do rise when interest rates rise as increases in interest rates are generally telegraphed beforehand and people rush to close a purchase before the higher interest rates come into effect thus driving up prices – it has been argued by many that this helped drive prices up in Canada in the spring of 2010.
2) The period from 1980 to 2010 while seemingly a long one was also an unprecedented period of declining interest rates – any increase in interest rates over that period was on a macro level just a short-term blip.
3) Comparing the increase in house prices from 1980 to 2010 to the increase in incomes over the same period is a more interesting comparison. While house prices increased dramatically income levels did not. The increased house prices were manageable because continually reducing interest rates over that period kept affordability in line with incomes.
Interest rates are a key factor in what will happen next to house prices – if they increase meaningfully they will reduce affordability and thus house prices.
If interest rates stay flat and as they can’t really go any lower you would get a moderate decline in prices as the market works through the price increase from the rush to buy before the expectation of interest rates going up then slow growth thereafter as house prices grow in line with incomes.
If the economy declines &/or babyboomers have over-leveraged themselves in real estate expecting continuing price increases to finance their retirements then you will see house price declines as people are forced to sell.
It is interesting to note that in the US it was the volume of house sales that declined (as we are seeing now in Canada) before the prices declined as sellers held on with the expectation of getting their prices and eventually those who had to sell driving prices down.
Hi Leo and Mike,
Thanks for your comments. A couple of additional points:
Mike, I’m not sure people change their home purchase timing based on short-term interest rate fluctuations as per your point in #1.
While average 5 year mortgage rates did certainly decline overall from 1980 to 2010, they actually increased month-over-month almost half the time (in 169 of 365 months).
My overriding argument was that the data does not support the assertion that rate increases will automatically have an immediate and negative impact on house prices. I think if and when rates increase, it will be because the economy is strong and prospects are good, so I would respectfully disagree that if rates increase meaningfully that that will definitely hurt house prices. If incomes are higher and we have upward inflationary pressure combined with rising consumer confidence, these factors may well offset the negative impacts of increased borrowing costs (or at least mute them).
I agree with your point that today’s low rates have brought forward future demand. I just don’t think meaningfully higher rates are around the corner.
For the record, I think the this phenomenon can partly be explained by demographics. Boomers have bid up houses prices for decades so you could counter my theory by aruging that “a rising tide raises all boats”. But I still found it interesting that the data was so counter-intuitive to such a widely held belief.
Dave
Dave said, “Mike, I’m not sure people change their home purchase timing based on short-term interest rate fluctuations as per your point in #1. ”
What? Of course they change their timing, especially if first-time home buyers. I heard, “You’d better buy before the rates go up” over and over again. I think this is one of the biggest drivers (along with “they’re not making any more land” and “you’d better get in before you’re priced out of the market.”
If you want to move a herd, frighten them! Fear is a great motivator.
Factoring in inflation, wages did not increase. This was a problem for TPTB: how do we get these suckers buying homes when they can’t afford to? I know, we’ll keep interest rates artificially low for too long, enticing initially the speculators (the first ones to the Ponzi game), and then the herd will follow. We’ll give them a wage increase in the form of lower payments.
Not only did they pull forward future demand, but they pulled forward an artificial wage increase.
Psychologically speaking, when you take people who never dreamed they would get into the housing market (and should never have been there in the first place) and practically lay a house at their feet (with 0% down and over 40 years), they will jump at it.
I say the PRIMARY driver of the frenzy has been a fear of interest rates going up, driving people into the market, which then consequently drives the price up.
Add to the mix the ridiculous CMHC (which makes the Ponzi scheme a thing of beauty). The banks get to lend to people they shouldn’t be lending to and, if it all turns out badly and buyers declare bankruptcy, voila, the taxpayers who were prudent get to bail the banks out. Oh, the sweetness of it all. The bankers can’t lose.
Fear and greed – a dangerous mixture that brings down countries.
The FIRE industry produces nothing, absolutely nothing. It needs to be put out.
An interesting thread…
Do people close houses faster based on speculation that an interest rate is going to go up? I don’t think so; would someone put off closing a house based on speculation that rates are going to go down? I think most would agree that this is unlikely, so why would the opposite be true. Short term Interest rate guessing is speculation at best and anyone that bought quickly in the past 10 years to avoid a micro rate hike that might happen next month is an idiot. Most home buyers are not idiots and would not rush into something as significant as a house purchase to avoid a micro interest rate hike that might or might not happen. Backwards evolution, you state that “I heard, “You’d better buy before the rates go up” over and over again. I think this is one of the biggest drivers (along with “they’re not making any more land” and “you’d better get in before you’re priced out of the market.”” What you are describing are sales tactics, not changing interest rates. Yes, sales tactics can drive sales and sometimes sales people use the threat of interest rate hikes as a tactic. What Dave’s post is about is wether or not house prices change in response to interest rate changes.
I agree that a huge rate hike would have a dramatic impact on affordability and if it happened in a short enough time period it might slightly deflate the housing market. What is more likely however is that the volume of sales will temporarily slow down as people ride out the bump. Most people would have no choice but to ride it out since many would be upside down in their mortgage and unable to sell. Interestingly, this highlights a key difference between US and Canadian mortgages that was at the heart of the US housing devaluation. In the US they have walk away mortgages, meaning that if you can’t make your payment you can drop your keys off at the bank and “walk away”. And thats what thousands of home owners did when they found that their houses were worth less than their mortgages. In Canada, if the bank can’t sell your house for enough to cover your mortgage you are responsible for the balance. It is interesting to note that US housing decline was completely independent of prime interest rates. In fact, american interest rates have only decreased since May of 2006.
Come one, it doesn’t take a rocket scientist to figure out that we are on a path of hurt. I believe disposable income to housing price ration is at 12 compared to when it was 9.7 during the 1980’s crash. It’s also supposedly reaching the level before the USA housing crash. How many times do you hear people say “how do they afford that house and the new car”? It’s cheap credit. We have a whole generation that do not realize that current interest rates are not sustainable and a fabrication of our governments to keep consumer spending up.
The reason short term rate increases have the opposite effect one would expect is that people get afraid and decide to go out a buy that new house to lock in on a rate before it goes too high. Sustained higher rates will cause mortgage payments to increase to the point where they are unaffordable and the bubble will burst.
It’s funny how everyone thinks that just because the prices have gone through the roof they have more asset, I wouldn’t consider your primary residence an asset. only the government is making more money on your increased property tax. The only way you would make money is to sell your place let’s say in Toronto and you move far far away to a small village 🙂
I really enjoyed reading the article and comments. I have wondering myself about this issue and have not really found a clear conclusion. Also data seems to differ across countries.
This makes good points, especially on income. Here is what I would add as food for thought not claiming to know the real answer:
I am not convinced a month 2 month analysis in this case is the best way. Maybe a moving average would be useful to use. Small up/downs are probably worth ignoring altogether and just focus on situations where rates increase by more than 1%.
Theoretically speaking a property value is given by the value of the rental perpetuity you can earn from it. This is roughly calculated: CurrentValue=(Expected Annual Net Rental Income)/Discount Rate.
The lower the Discount Rate the higher the value and vice versa implying rates matter a lot.
The only way to offset this is higher Net Rental Income which occurs when Income is rising or there is a shortage of housing.
The whole analysis is a bit blurred by the fact that it is easy to find out how interest rates have changed but on EXPECTED Rental Income we don’t really no. The only proxy is current rental income which is not the same.
My gut feeling is there is more to the property price than just rent and interest rates but I am not sure how and where to figure this in.
If you go back 30 years, people were paying 2 or 2.5 times the average income (or even lower than 2 if you were willing to fix her up a bit). It was like that for most of the 80s, 90s and even early 2000s.
Obviously, I’m talking about my general area, so that ratio might not be exact in all cases, but the trend should be about the same.
In short, the further you go back, the more people could afford an extra point on the mortgage. I mean, if you qualify at 8% (early 90s), is 9% that big of a deal ? You probably paid a good bit in the last five years anyways so that increase won’t hurt much.
Now, considering people are easily paying 3-4 times (even more in the hot areas) the average income at around 3, 3.5%. At those rates, a point is an increase of around 30% (!!) vs 12% for an increase from 8 to 9.
There’s also the fact that old school planning was 25% of income for housing, so yeah, bring on an increase. Now, very few people only spend 35% of their income on housing. Can you afford a 4.5% mortgage when you spend 45% of your income on housing ?
So it’s not clear cut to me. Obviously, if rates go up because wages are rising significantly, you may still end up being right!
Thanks for your note Francis.
If rates go to 8% or 9% then I agree that borrowers are far less suited to afford that kind of increase today than they were in decades past, but for my part, I don’t see a return to those rates any time soon (for reasons that I have outlined in many of my posts but that are too numerous to detail here!)
Also, I don’t think most folks spend 45% of their income on housing. If they did, I couldn’t qualify them for the mortgages I typically offer and for my part, most of the borrowers I work with are closer to the 35% range. Still higher than yesteryear for sure, so I’m not dismissing the point, I’m just not seeing the gap as wide as you are.
Best,
Dave