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Thursday, August 11, 2016

Housing - Buy, Sell, or Rent? Fed's Goal to Keep You Betting Against Fundamentals?

US home prices have rebounded and now sit just 3% below the 2007 record valuations (chart below).  Seems a good time to consider if it's time to buy, sell, or rent.
US Housing Valuation Index

Role of Interest Rate Cuts on Housing Prices
How is it house prices have gone up so much anyways?  You can thank the Federal Reserve for that.  The Federal Reserve has been cutting the FFR (Federal Funds Rate) since 1981.  The 30yr mortgage (roughly linked to the 10yr Treasury yield + fees) has been falling with each cut to the FFR along the way (chart below).  If your curious why rates rose so much and have fallen so long, so low, and will likely only keep falling (HERE).

Since the 1981 peak, the Federal Reserve has lowered the Federal Funds Rate by 97% and the 30yr mortgage has followed, declining by 81% over the same time period (chart below).

This means that to borrow $100,000 in 1981, it cost $1426/mo (principal & interest) at the then 17% 30yr fixed mortgage rate.  As rate cuts were deemed appropriate by the Fed, the cost of credit continually fell.  The same $100 k loan only cost $699/mo by 2000, is only $443/mo now (chart below)...and assuming the 10yr hits 0% by 2018 (not a stretch as many other major 10yr bonds are presently sporting negative yields), the cost of a $100k could be as low as $370/mo.  (This assumes money is free but banks still get their approx. 2%).

But American's didn't take out smaller loans.  Instead, the same monthly payment was necessary to keep up with fast rising home prices (rising because of the declining interest rates).  With the same $1426/mo loan, the homeowner now controls over 3x's the debt with the same interest payment.  And homeowners will control 4x's the debt once the 30yr mortgage hits 2%...and that will be necessary because the house price will likely have gone up 5x's thanks to decreasing necessary down-payments and the like means to put homeowners into ever more debt for the same house.

However, if the Federal Reserve is sincere in it's proclamations that it has begun a rate hike cycle, the implication for housing as interest rates rise...is home prices will decidedly fall as a greater proportion of the monthly payment must go to interest service rather than principal repayment.  Systemic implications abound if the Fed were to be believed regarding rate hikes, especially considering the following trends...


Supply of New Housing vs. Demographics & Full Time Job growth
Some historical context...the demographic outflow of boomers and decelerating inflow of 15-64yr/old replacements is entirely unlike any previous period in the US.  Add in the deceleration of net new full time job creation (by both quantity and quality of full time  jobs) and this wouldn't seem to add up to higher home prices but many things aren't what they seem nowadays. 


86-->01

  • 13 million new homes were added
  • 29 million increase in the 15-64yr/old population
  • 24 million net new Full Time jobs
  • 01-->16
  • 13 million new homes were added
  • 22 million increase in the 15-64yr/old population
  • 9 million net new Full Time jobs
  • 16-->30
  • ? million new homes were added***
  • 5 million increase in the 15-64yr/old population (includes anticipated immigration)
  • ? million net new Full Time jobs

  • ***If less than 13 million new homes are added over the '16-->'30 period, GDP (flawed as it is) will take a big hit without all the secondary and tertiary housing induced activity.  If 13 million or more are built...there don't seem to be adequate buyers and what will the impact of significant excess housing units be on the overall housing market?


    Over the next presidents term, there will be 3.5 million more 25-64yr/olds (potential buyers) vs. 14 million more 65+yr/olds (potential sellers).  This is a situation that has never taken place before in America with such an imbalance of potential sellers vs. potential buyers.  The 65+yr/olds will be net sellers downsizing moving to condo's, townhomes, or even moving to managed care.   Plus, upon their passing, the homes will generally either be sold or passed to their 25-64yr/old heirs (whom will more often than not sell the properties).

    But wait, it gets worse!  Since 2000, the 25-54yr/old population has grown by 5 million persons, but full time employment among this group has shrunk by a half million.  On the flip side, the 55+yr/old population has grown by 31 million over the same time span but the real kicker is all the net new full time jobs went to the 55+yr/olds.  So, this cohort that will be moving into retirement has continued working in an attempt to bridge shortfalls in retirement savings and avoid paying health care costs until Medicare and Medicaid kick in.  Some of the depressed wage gains are likely due to 55+ boomers willing to work for less particularly to keep their benefits.  But this has left much of the 25-54yr/old population without means or savings to become future potential buyers.

    Alas, you need to live somewhere and if you don't own...you will likely need to pay rent.  And renters are getting creamed (chart below).  While the national housing index is still 3% below the '07 "bubble" peak, the rental index is 27% higher than the then record rents of 2007 (no talk of a "rent bubble"?).

    Of course, fast rising rents absent rising real incomes means rent is taking a record portion of renters income.  And this means that renters are generally too busy paying their rents to think about becoming first time home buyers...taking away another group of potential buyers.   But at least homeowners have tax advantages (so long as they have income to shelter) writing off their mortgage interest.


    So, is it time to buy at record valuations or time to sell at record valuations (and rent at record rates)?  After all the negativity above, some may be surprised to hear me now say residential real estate meets some pretty basic needs and provides a tangible asset...and based on the level of leverage may be one of the better assets in the coming fight between the natural deflationary forces vs. government and central bank synthetic counter-inflationary measures.  Don't misunderstand me, I believe real estate will lose value and perhaps significant value...but money must go somewhere and on a relative basis vs. stocks, bonds, cash, & commodities; residential real estate is unlikely to go to zero as other assets may and is a portion of my portfolio.  I just think the above information is key in setting expectations.  Lastly, precious metals are separate from commodities and a different discussion for another day.

    6 comments:

    1. San Francisco Bay Area real estate will rise forever.

      https://www.reddit.com/r/personalfinance/comments/3ojwge/how_can_foreverrising_housing_prices_be/

      http://greyenlightenment.com/tag/bay-area-real-estate/

      ReplyDelete
    2. The Fed sets the funds rate? I thought it was set between the lending and borrowing banks? I thought interest rates were set by the market, not the Fed. Hmmm. I think rate a low not because the Fed lowered them, but because the markets were running out of borrowers. Why would the funds rate rise when Banks are full of cash? Seems like interest rates generally reflect the demand for money and that this demand is now low. The Fed didn't do it. Get a clue buddy.

      ReplyDelete
      Replies
      1. In the days before '08, to raise rates, the Fed's FOMC would sell bills and bonds to banks, paid for from banks excess reserves, tightening available money for lending from excess reserves. This would force overnight interbank lending rates higher (the basis from which all other rates are set) and that would begin effectively filtering its way through market rates. However, that was in the days when excess reserves held by banks were like $25 billion...so a little open market operation by the Fed to remove (or hike) by a couple billion here or there was all it took. Now, banks hold something like $2.5 trillion in excess reserves. So, for the Fed to tighten overnight rates, the Fed would need to remove something like $2+ trillion to make any impact. Not gonna happen and Fed has admitted this.

        As the Fed has begun raising rates, the plan is that QE will continue alongside interest rate hikes. At the minimum, the Fed will continue to repurchase maturing bonds to maintain its $4.5 trillion balance sheet while simultaneously hiking IOER payments (Interest On Excess Reserves held at the Fed). The IOER's are meant to de-incentive new lending. So, if they can continue repurchasing while hiking rates, there really is no reason they couldn't increase their holdings (embark on QE4 or 5 or whatever it is now) simultaneously..."if economic conditions warranted"?!?

        That's why the "plan" (this has never been done and is totally theoretical) is to increase IOER's (interest on the excess reserves banks hold) so banks are de-incentivized to lend as they can get higher returns parking money at the Fed?!?

        Delete
      2. UnknownAugust 20, 2016 at 2:19 AM

        "...I thought interest rates were set by the market, not the Fed. Hmmm..."

        That's because you're like 10 years out of date, buddy.

        Delete

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