Can Rising Interest Rates Be Good for Real Estate Investors?

It’s midway through 2018 and the economy continues to perform well, housing prices are rising, and the Fed is raising interest rates. What does this mean for home owners, buyers, sellers, and real estate investors? One way we assess the likely effect of rising rates at Hardscrabble Investments is by learning from the past. While researching historical interest rates, we found a great report that was recently published by Doug McManus and Elias Yannopoulos, both members of the economic and housing research group at Freddie Mac. Their report recaps the history of rising interest rates and explains the impact to single family home buyers, sellers, and the real estate market in general. Over the last 50 years, there were several periods where interest rates rose, often dramatically. These periods provide examples of what we can expect today. The report also projects three scenarios for the future of rising rates and what could be ahead of us this time.

We’ve summarized the content below and added our thoughts regarding the impact to the single family real estate market and real estate investors alike:

• Rising interest rates decrease the supply of housing on the market because homebuilders slow down construction of new homes and current homeowners delay selling and buying new homes at higher rates
• Lower housing supply increases the price of homes on the market; prices also tend to increase with rising rates due to the correlation with rising inflation expectations
• Lower supply, higher prices, and less purchasing power due to higher interest payments causes an increase in the number of renters as many first time buyers delay purchases or can’t qualify and current homeowners delay the sale or purchase of a new home
• As a result, occupancy and rental rate increases should remain strong through a rising rate scenario boding well for net operating income of rental properties.

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Can You Believe It? Interest Rates Doubled from 1977 to 1981!

The most extreme scenario of rising interest rates in the last 50 years occurred from 1977 to 1981. In 1977, a person looking to buy a home could walk into a bank and apply for a 30-year fixed-rate mortgage at around 8%, which is high in today's standards. Fast forward 4 years to 1981 and the same person applying for the same loan would receive an interest rate of 18%. That is a 10% increase in just 4 years! It almost destroyed the mortgage and housing industry in the US. The dramatically rising rates resulted in:

• A 36% decline in single-family home sales annually from 4.5 million to 2.9 million
• A 51% decline in new construction of single-family homes from 1.5 million to 705,000
• A 40% decline in new mortgage originations from $162 billion to $98 billion.

Since the 1981 period of high-interest rates, mortgage rates have overall progressed on a generally downward trend through to today’s ~4% rates. However, there are shorter, less severe periods of rising rates in between. Further analysis of these periods shows a similar, but less dramatic impact to the housing market. Since 1990, there are six periods where the rate for 30-year fixed-rate mortgages has increased around 1% in a short time frame. These six periods have almost always seen an accompanying reduction in home sales, housing starts, and mortgage originations. On average, the 1% increase in interest rates decreased home sales by 5%, housing starts by 11%, and mortgage originations by 30%.

The blow chart shows the Historical Interest Rates for 30-Year Fixed-Rate Mortgages

Could rates soar again? Of course! Will they rise to the levels seen in the 1980s? It’s doubtful anytime soon. Rates that high would imply dramatic inflation which most economists do not expect to develop based on current macro-economic trends. The consensus is that rates will rise but not to these extremes. But only time will tell.

What Effect Do Higher Rates Have On Borrowers?

The direct effect for home buyers, and borrowers in general, comes down to the total cost of financing: principal plus interest. Decisions as to which home to buy, when to buy, how much to buy or whether to buy at all, are heavily influenced by mortgage rates. The higher the rate, the higher the monthly payments required to finance the purchase of a home. As the monthly payment needed to purchase a home goes up, buyers tend to delay their purchases until more favorable rates allow them to afford the home they desire.

This is particularly true for potential first-time homebuyers who may find that they can no longer afford some houses for two reasons:

1. The extra financing costs stretch their budget too far

2. They can no longer meet the lender’s debt to income requirements.

For those who already own a home, the choice to buy a new home in a period of rising rates is linked to the decision to sell. This is because the homeowner often uses the equity in their current home for a down payment on their next home. When a homeowner evaluates the options for new financing they realize they are giving up below market financing in order to sell their home. In addition, the buyer has less purchasing power with more of the monthly payment going to interest payments meaning they can’t afford as much house. This option is less attractive than the homeowner’s current situation. Many homeowners will delay both selling and buying homes to keep their under market value financing.

As a result, many home buyers delay their decision to purchase and choose to rent. This pushes up the demand for rentals and works in favor of investors looking to purchase single family rentals and multifamily apartment buildings. It’s very likely that increasing rates will push up the pool of renters and continue to support strong demand for rentals. Occupancy is likely to remain strong and should support rental rate growth as well.

What Happens to Housing Supply and Demand?

As described above, as rates rise, the cost of financing the purchase of a home increases due to the larger interest payment on the loan. This results in a decrease in demand from homebuyers. Economics would suggest that the price of houses would decrease to match the buyer’s expectation for the total cost of purchasing a home. However, history shows that the price of homes tends to increase as well during periods of rising rates. Why is this?

To understand why home prices would increase during periods of rising rates, we have to look at what is happening with the economy and the supply of housing. When interest rates rise the economy is typically doing well, pushing up inflation expectations. This in turn causes interest rates and prices for all goods and services to rise, including housing. In addition, there are supply and demand changes occurring. When rates rise, a home builders cost to build and hold a home until sold increases dramatically. Therefore, the price at which a builder will sell a home goes up and the supply of new homes tends to decrease. On average over the six periods of rising rates, housing starts decreased by 11%.

As described above, the same is true with current home owners who are considering selling and purchasing a new home. They tend to delay the decision until rates decrease again. As a result, the supply of homes on the market decrease as well, as those who can wait to sell, wait. Overall, this results in a 5% decrease, on average, in home sales.

But not everyone can wait to buy or sell a home. Many families grow and need more space. Some find new jobs and must relocate. Demand for the houses that are on the market go up and in turn, the lower supply drives prices up. Builders also factor in higher costs of financing into the newly constructed homes. As a result, on average, housing prices rose 8% during periods of rising rates.

In many ways, today’s environment of low housing supply reflects this imbalance and has driven price increases. Many cities, like Dallas, are seeing this scenario play out today (see this article). Rising rates could further accelerate housing price increases by depressing supply even more. As these factors play out, increasing prices, lower supply, and higher costs, renting will remain an attractive option. Demand for rentals, whether single family homes or apartments is likely to increase in a rising rate environment.

What’s in Store for Us this Time?

Based on the mortgage rate cycle history, McManus and Yannopoulos see three possible scenarios playing out:

1. The first is status quo; that rates will hover around 3.5% to 4.5%, moving in a similar pattern to the year-over-year change during the recovery phase of the housing market since 2011. This scenario generally resembles today’s market and would result in moderate increases in sales, housing starts, and mortgage originations as rates remain relatively low compared to historical averages. Prices would likely continue to rise moderately as well.
2. The second scenario would see rates increase similar to those seen during the six periods of rising rates since 1990. This implies an increase in rates of 1.5% to around 5.5%. In this scenario, home sales decline by 5%, construction decreases 11%, and mortgage originations fall by 30%. Prices, however, continue to increase by 8%.
3. Scenario three would see an increase in mortgage rates for a long and extended period of time. This implies a period of higher inflation where mortgage rates would increase by up to 2.5% and result in a 14% drop in home sales, 32% drop in housing starts, and a 49% drop in mortgage originations.

How We Prepare for Higher Interest Rates

In the near future, rising mortgage rates could become more of a reality than a discussion point. Mortgage interest rates are closely correlated to inflation expectations. If the economy continues to perform well, or even improve, inflation will continue to rise. With rising inflation expectations, mortgage rates will continue to rise in tandem.

At Hardscrabble Investments, we monitor interest rates and evaluate the potential effect on our investments. When evaluating our investments, we create financial models that factor in a variety of interest rate scenarios that could occur. These models stress test our investments based on how interest rates could change and how this would affect our investment returns. One of the ways we try to limit interest rate risk at Hardscrabble Investments is to work with partners that secure good financing in preparation for rising interest rates. Generally, this means locking in fixed rates with longer-terms of 10 years or more. This helps to prevent large swings in debt service or the need to refinance at a point when interest rates are peaking. By doing this, we are able to understand and limit the risk of our investments, bringing quality returns and peace of mind to our investors, even in tough financial markets.

There is no guarantee of when and by how much rates will rise, but by understanding similar periods of rising rates, and the potential effects on our investments, we can work to limit the impact. We hope this article is helpful in evaluating your investment decisions and we look forwarding to hearing your feedback.

Related Articles:

Doug McManus and Elias Yannopoulos (2018). Freddie Mac economic and housing research group. Nowhere to go but up? How increasing mortgage rates could affect housing

Dallas News: Higher home, mortgage prices mean first-time buyers are paying 19 percent more each month

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