Santa Barbara is a wonderful place to call home. Despite the higher cost of living, we all choose to live here because the benefits are worth that added expense.
Buying a home here, regardless of the local, state or national economic situation, is challenging. Recently we've seen a firming in our local real estate market, with certain price points gaining ground, and even some bidding wars occurring for properties in the sub-$1 million range.
However, the local real estate market has benefited, as have all markets across the United States, from historically low mortgage rates. With the Federal Reserve set to taper off on its massive bond-buying program — QE 3 (quantitative easing round 3) —interest rates have been moving up in anticipation. The ramifications of a rising interest rate environment on real estate are significant, serious and inevitable.
I spend a substantial amount of my time each day studying the economy and financial markets. One of the most challenging, sometimes enjoyable and always frustrating aspects of my business is the multitude of variables that must be considered when making investment decisions. Unlike many other asset classes, real estate has a very highly correlated inverse relationship between prices and interest rates, meaning that when interest rates move in one direction, real estate prices always move in the other direction.
In the nearby chart, I've presented U.S. median home prices from 1963 through 2013 compared with the 10-year Treasury rate over the same time period. We can very clearly see that over this 50-year time frame, home prices have moved in the opposite direction as rates. While there can be some short-term periods in which they both move in the same direction, the longer-term relationship is very evident. Of note is that the most recent few years, since the economy has begun to recover, both rates and real estate prices have risen together. This is certainly an anomaly and is unlikely to continue.
This direct correlation for home prices and rates can best be explained by the fact that rates in general are at historically low levels, so even after the recent increase, they are still extremely low, meaning that mortgage rates are still relatively affordable, and the sizable declines in real estate prices that resulted from the 2008-2009 economic collapse. It is normal for any asset class to experience a short-term bounce after such a massive decline.
We should not expect prices and rates to continue to move in the same direction. As rates rise, mortgage payments will be increasingly higher for a given home price, resulting in declining affordability. This means that home prices must decline as mortgage rates rise, to maintain affordability at the same level. In other words, as rates rise, if a buyer wants to have the same mortgage payment, the house price must go down. For a home with a $1 million loan at a 4 percent 30-year fixed-ate mortgage, the payment would be about $5,800. If rates were to rise to 5 percent, the same $1 million loan would cost $6,400 per month. To get the payment back down to $5,800 with the mortgage rate at 5 percent, the loan amount would have to decline to about $880,000, or by $120,000 (12 percent). It's easy to see how rising rates can have a very negative impact on home prices.
The chart above shows Santa Barbara median home prices versus the 30-year fixed-rate mortgage from 1991 through 2013. Again, as with the previous chart, except for the most recent period, the relationship is clearly inverse and highly negatively correlated.
While other factors such as inflation, incomes, GDP growth, etc., can certainly affect home prices, interest rates are one of the most important determinants of home prices over the long term. What will be most significant in the coming few years will be the pace of the increase in interest rates — if rates can rise at a relatively slow and controlled pace, it is at least possible that home prices, at least in our local market, can avoid a sizable further drop. If rates rise dramatically over a relatively short time-period, however, we could easily see a second leg down for local home prices.