Forget Rates: Why Housing Prices Suggest the Recovery Will Gain Strength
With QE and the Fed at the forefront of everyone's minds these
days, let's take a step back and look at what's going on in
housing. We know that mortgage rates have moved from December lows
of 3.4% on a 30-year fixed mortgage to where we are now, which is
We also know that roughly 70% of Americans own a home, thus constituting a very large portion of GDP -- to the tune of 17%. The "trickle-down" effects are immense, and perhaps best represented in terms of scope by the SPDR Homebuilders ETF (NYSEARCA:XHB), whose main weightings are Lennox International ( LII ), Lowe's ( LOW ), Bed Bath & Beyond ( BBBY ), Mohawk Industries ( MHK ), Williams-Sonoma ( WSM ), Home Depot (HD), and Toll Brothers (TOL).
This being the case, it's only natural to try to predict where the housing market is heading, given our current environment. First, we may need a history lesson. Looking at the last decade, where housing was most definitely one of the primary issues leading up to the Great Recession, we can learn a lot about certain trends and patterns that might better help us in our current position.
Beginning in the year 2000, Alan Greenspan, former chairman of the Federal Reserve, brought about rises in interest rates several times. He believed that the economy was going too strong for its own good (remember "irrational exuberance"?) and that an increase in interest rates would help slow it down. In particular, the stock market was growing too fast, and Greenspan was hoping that the increase in rates would slow it to steadier levels. These actions taken by Greenspan were believed by many to have caused the bursting of the dot-com bubble in March 2000.
Let's take a closer look at the change in certain rates before and after the dot-com crash. At the start of 2000, discount rates were at 5.5% and increased in intervals of .25% until they reached 6.5% by the end of the year. Thirty-year fixed mortgage rates were also on the rise, reaching a max of 8.52% at the peak of the bubble. From then on, however, mortgage rates dropped until they fell to almost 5% in mid-2003. In response to the crash and the 2001-2002 recession that followed, the Federal Reserve lowered interest rates to historically low levels, from 6.5% to just 1%. By November 2002, the discount rate was at a low of .75% and the target Fed funds rate was at a near-low of 1.25%. Mortgage rates were dropping as well, seemingly in sync with the rapidly falling interest rates, as one might expect. Such a sudden and dramatic change in rates resulted in lenient lending practices and easy approval for banks to give out loans and mortgages. This sparked the beginning of the housing bubble, which resulted in some serious repercussions. Greenspan even admitted that the housing bubble was "fundamentally engendered by the decline in real long-term interest rates."
When interest rates began to rise again in 2003, it took a long time for mortgage rates to react; mortgage rates did not really begin to rise again until 2006, even though interest rates had been constantly on the rise since 2003. The yearly averages for mortgage rates in 2003, 2004, and 2005 were 5.83, 5.84, and 5.87, respectively. One can see why the argument can be made that current mortgage rates are still historically low.
All the way up until June 29, 2006, rates constantly rose under the direction of the Fed until discount rates peaked at 6.25%. With interest rates on the rise, 30-year mortgage rates peaked at 6.53% in June 2007, which was a ten-month high. This was preceded by housing prices peaking at 206.52 in July of 2006, as indicated by Case-Shiller 20-Composite Index. That's when the housing market began to crack, and it eventually shattered. In terms of housing, the resulting foreclosures increased supply, causing a drop in housing prices. Home prices continued to fall throughout 2006 and 2007, eventually becoming a major cause for the recession that began in 2007.
After the housing crash, interest rates began to steeply decline once again, mainly via the Federal Reserve's easy money policies, known as quantitative easing, or QE 1, QE2, and currently, QE3. They have remained historically low ever since. The Fed discount rate currently remains at 75 bps, and the federal funds rate is at 25 bps. Mortgage rates also fell steadily and did not begin to rise again until recently.
But now, mortgage rates are back on the rise, and there is a worry that this might stunt the housing recovery. And with housing being a key component of the health of the economy, this could be a cause for concern.
A SUBJECTIVE LOOK
Intuitively, it might seem that increased 30-year mortgage rates would indeed slow down the housing market because less people would qualify for costly mortgages, and fewer people would want to take out expensive mortgages to begin with. Historically, however, specifically in the past decade, mortgage rates actually had little to do with fluctuations in the housing market.
Statistically speaking, in periods of both increasing and decreasing rates, home sales and mortgage rates have shown little correlation. In a compilation of existing home sales data (85% of the housing market) since 2000 in comparison to 30-year mortgage rates since the same year, we find that the coefficient of correlation did not exceed 128 in any of the three periods of interest rate changes (2000-2002, 2003-2006, and 2007-2012; see chart below).
In layman's terms, a correlation coefficient near zero indicates that the two sets of data are not closely related -- neither one changes in response to the other. And since existing home sales make up 85% of all home sales, a low correlation between mortgage rates and existing home sales is a strong indicator of mortgage rates' relationship with the housing market as a whole. This leads me to believe that rising mortgage rates, to this point, should have little to no impact on the current housing market.
Instead of looking at 30-year mortgage rates, let's look at home prices (represented by the Case-Shiller Composite-20 Index) versus home sales. Movement in the Case-Shiller Index since 2000 has shown remarkable similarity to movement in the number of existing home sales since 2000. Looking at their respective graphs from mid-2000 to mid-2013, it's easy to see a very similar pattern: Both show a steady increase until peaking around December 2005, followed by a decline and a leveling off. Furthermore, the correlation coefficient of existing home sales to home prices from 2000-2002 was a solid .719, followed by .483 from 2003-2006 and .480 from 2007-2012. These numbers clearly outmatch the correlation between home sales and mortgage rates. And looking at the graph of existing home sales side-by-side with the graph for mortgage rates, there is no immediate trend or resemblance that appears. Based on this evidence alone, it appears evident that home sales are more closely related to home prices , and are not as closely related to mortgage rates, as we sometimes think.
Along with home prices, the strength of the housing market can also be closely gauged by the National Association of Home Builders Market Index. The NAHB is a monthly survey that reports the sentiment of home builders regarding current home sales and future expectations of sales. A reading above 50 indicates that home builders are generally optimistic and view conditions as good. In a comparison of existing home sale data to the NAHB from July 2000 to July 2013, the two showed a very close resemblance, as demonstrated by the graph below:
Boasting a correlation coefficient of .850 from 2000-2013, home sales and NAHB data is a valuable guide as to what direction home sales might be moving. And since the NAHB reached 51 for the month of May and 57 for the month of June (up from 41 in April, and 44 in May), it seems safe to say that a modest rise in home sales should soon follow.
In this vein, we reached out to the Executive Vice Chairman of the NAHB, Andrew Chaban, who also happens to be the CEO of Princeton Properties, one of the largest purveyors of multi-family housing in the country. In fairness, the first question I asked Andrew was whether higher mortgage rates are having an effect on the market. His response? "Of course they are, but to this point, mainly from a portfolio perspective." He then gave an example of how a $111 million portfolio he refinanced one-and-a-half months ago at 3.74% would now be at 5.3%, or cost an additional $2 million per year in interest. That said, most in his industry were "expecting" and "prepared" for this rise in interest/mortgage rates, he explains. Also, the supply demand curve in most anchor markets is still very much in favor of the builders/sellers and property managers. As Andrew put it, "Life will go on, and a lot more housing, both multi-family and single family, is needed."
Many have pointed to weakness in June data since rates have risen. We got the first glimpse of perceived weakness with June housing starts, which showed an extremely large 26.2% month-over-month drop in multi-family starts. To this, Andrew actually laughed, saying, that given the volatility and the unpredictable nature of when permits are pulled, you can only look at housing starts at a minimum on a quarter-to-quarter basis; they cannot be measured month to month. He concluded by saying that most likely, by the end of the year, we will see "continued steady progression," with the caveat that credit does, in fact, remain constrained in terms of bank lending.
Similarly, June existing home data, reported on July 22, came in below expectations of 5.26 million units, at 5.08 million units. Moreover, May's off-the-charts 5.18 million unit surprise was revised down to 5.14 million units, which is still a healthy number. But again, data shows that housing prices have a higher correlation than increasing or decreasing mortgage rates in relation to housing sales/purchases. From that perspective, in June, we also learned that the median price of homes sold went from $251,000 to $261,000, a 5-year high. Overall, home values are up 12% year over year nationally; in California alone, home prices have risen 28.3% year over year.
Finally, distressed sales in June as a percentage of total sales dropped from 18% to 15% month over month, and they are down from 25% year over year. So if one believes -- like we do -- that home prices, as opposed to mortgage rates, are the most important metrics in sustaining this recovery, common sense dictates that as more distressed properties are worked off the market, housing prices should continue to rise.
Swinging back to Mr. Chaban, he ended by again reiterating (in the context of higher rates) that "life goes on," and that he believes that at this point, the effect of "higher rates will most likely translate to a potential buyer buying less house, as opposed to not buying," thus mitigating the effects of higher mortgage rates. Andrew remains extremely constructive on housing for the foreseeable future.
Ben Bernanke himself has pointed to housing as one of the "bright spots" of the economic recovery. Bernanke recently espoused his belief that housing is again being looked at, by most Americans, as their number one investment. Again, we contend that as long as housing prices continue to rise, there should be little effect on housing, given supply /demand favorability, and restored faith from an investment perspective. The latter factor is important because under the premise of rising home values, home equity inherently increases, theoretically creating more personal wealth and trickle-down effects that may result from home equity lines of credit.
In light of some of this new evidence, using mortgage rates solely as a guide would be mostly unhelpful. There is a caveat here, as many economists contend that an inflection point may occur if the 30-year fixed rate eclipses the 6% threshold. This could be a psychological barrier for many buyers as well. Instead, we should look to home prices as a guide. Since prices are on the rise as well, one can conclude that the housing market will continue to strengthen in the coming months. Despite rising mortgage rates, the housing market will not stagnate -- in fact, it will improve. All it takes to prove this is a look at the last decade, from which there is most definitely a lot to learn.
And a bullish attitude never hurt, either.
About the Authors:
Joe Digiammo is the Managing Director of Equities at Mischler Financial. Prior to joining Mischler, Joe worked for Morgan Stanley in New York City in institutional equities, as a position trader and sales trader. In total, he has more than 18 years of experience in sales/trading and management.
David Michalowicz is interning with Mischler Financial Group this summer. He is a sophomore math major at Carnegie Mellon University.