In this special issue on real estate, I decided to share with you some important information on the role of interest rates in the real estate market. I hope you will find it, of “interest.” (Get it?)
While there are of course exceptions, most people will borrow money when they purchase real estate. In many ways this can make real estate an attractive investment; for no other hard (and typically, to some degree at least, appreciating) asset can a person borrow a significant portion of the purchase price.
Generally speaking, the rate of interest depends on various factors, including:
- availability of funds in the market (there are times when funds are amply available, as well as times when money is tight;
- perceived credit-worthiness of the borrower;
- required profit for the lender; and
- the rate of inflation in the economy (both current and anticipated).
Stir these all up in a pot, plot it all out over a 50-year timeframe, and you get a very jagged line with many ups and downs. In this analysis, I will use the rate of interest adjusted for price inflation – known as the “real rate”. And since we are in election season (yet again), I decided to show you something a little less jagged.
Chart One shows the average inflation-adjusted rate of interest on a 30-year mortgage, broken out by timeframe of various presidents’ terms of office, going back to 1973 – the start of Richard Nixon’s second term. In this nearly 50 year timeframe, you should note a couple things. First is the very high real rates that prevailed during President Reagan’s term in the 1980s. Generally, that was a time of considerable growth in the economy and in the stock market. Yet in his first term the typical real interest rate on a 30-year mortgage was more than nine percent! (The actual rates were in the 12-14 percent range, as consumer price inflation was around four percent.)
Then you should note how real rates have been declining over time, since Reagan’s first term. The average prevailing real rate in President Trump’s term has been 2.3 percent. In addition, there were times in President Obama’s first term when the real rate actually dipped below one percent. (But more on that in a moment.)
The price of money (as reflected in the real rate of interest) indeed has an impact on real estate prices. Chart Two is a repurposed version of the “bubble chart” I have shown in a couple previous columns. Instead of showing the actual values, the chart shows the year-over-year change in real estate prices here in Broward County, adjusted for inflation.
Start by taking a look at the first 20 or so years. You note the line is bouncing along pretty close to the zero axis line. That is because, adjusting for changes in the price level, real estate prices here in Broward County essentially did not change in that entire timeframe! But then recall the first chart on interest rates. All through that time, it was relatively expensive to borrow money for real estate, even though real rates were decreasing. In addition, that was a time of a tremendous boom in the securities markets, and undoubtedly many investors believed that stocks were a better investment than real estate in south Florida.
It’s also worth noting that there was a lot of new construction going on in the western half of the county. Supply was keeping up with demand much more robustly than in other timeframes, such as today, generally, unless you look at the downtown Fort Lauderdale skyline (there are always exceptions).
Now, most of us know what started happening around 1999 and continuing for about seven years – an unprecedented boom in real estate prices, in south Florida and in many other parts of the country. In inflation-adjusted terms, prices here increased by 130 percent!
Yes, real interest rates continued their gradual decline. But something else happened: mortgages became much more available, both through relaxation of lending standards and from introduction of new and innovative (or so many thought at the time, which ultimately turned out to be risky) types of mortgage products. Chart Three shows the spike in availability through 2006.
And then lenders’ wallets slammed shut.
Real interest rates kept falling a bit. But with credit not as freely available, and a recession in 2008-09, prices in the hottest markets (like South Florida) plummeted. In inflation adjusted terms, prices here decreased by 52 percent from peak to trough.
Many lost big. But many who were wise enough to buy in the 2010-2012 timeframe, and had access to capital, gained big (or, if you prefer, bigly).
A strong economy, continued decreases in real interest rates, a degree of loosening of lending standards relative to the early 2010s, and high demand for property here led to higher prices (though not percent increases like the early oughts bubble). As mentioned earlier, having real interest rates below one percent was something of a catalyst for the turnaround. On an inflation adjusted basis, prices have increased by more than 60 percent since the 2011 trough.
Which brings us up to the present. Price increases have slowed, and while interest rates continue at their lowest levels in more than 40 years, days ago it was reported that the manufacturing sector in the US has gone into recession. Many project that other sectors of the economy are soon to follow.
Absent weakening of lending standards (probably unlikely), it is unclear where support for housing values will come for the next several quarters. Which leads us, finally, to Chart Four. There is really not much room for further mortgage rate reductions. So in Chart Four I plotted out the dollar impact on the monthly payment (principal and interest only) of a $250,000 mortgage, at various actual (not inflation-adjusted) rates of interest. As a rough rule of thumb (just to tuck in your pocket) every half a percent increase in interest will increase the monthly payment on a $250,000, 30-year mortgage, by about $75 (all other things being equal).
I hope you have found this to be an educational and interest-ing discussion!
James Oaksun, Florida's Real Estate Geek(SM), is Broker-Owner of New Realty Concepts in Fort Lauderdale. In addition to having degrees from Dartmouth and Cornell, he is a Graduate of the Realtor Institute (GRI).