"negative rates distort everything" warren buffet. how about RE?
Flipper/Rehabber · Las Vegas, NV · Member since 2016 · 174 posts · 251 votes
The gravitational pull of interest rates according to Warren Buffett. How does this affect housing prices? must watch video for real estate investors.
@George Gammon , @Gloria Mirza, and @Nick L., great commentary.
With all this discussion of wages, home prices, interest rates, and qualification, I have to refer back to one of my favorite pieces of data that I haven't been updating lately: The Housing Affordability Index!
Here's some good historical HAI data I got together and analyzed mid-last year. I'll update it in not too long..
Scroll down a bit and look at how interest rates impact home price qualification. A lot of support came from decreased rates.
HAI from November: (courtesy of Paragon's Patrick Carlisle's work, with link:
http://www.paragon-re.com/Housing_Affordability_and_Market_Corrections )
INTEREST RATES AND RE CYCLES
In regards to George and Gloria's comments regarding the direction of interest rates and RE prices, I think we really need to differentiate the short term from the long term, and what is going on in the background. In the short term, increases in rates can cause all kinds of counterintuitive behavior (buyers buying more at higher prices expecting even higher rates). When rates are increasing over a cycle, it's usually because employment and lending conditions are improving, optimism improving, more cash on hand, oftentimes more than offsetting higher rates.
What I think we can say with a high level of certainty, is that in any given economic backdrop, lower rates would very likely cause higher prices, and higher rates would very likely cause otherwise lower prices. Imagine if the 30yr fixed mortgage rate was only 2.0% instead of 5.5-6.5% during the peak of the last market, with everything else (optimism, super loose lending, etc) the same (ceteris paribus as they say in econ...) My god!! Things would have almost certainly gone crazier. Conversely, imagine if, under the same circumstances, rates were 12%. Would things have been different? I have to say almost certainly, at least one home would have sold for less! lol
Inflation, Deflation, Fed Balance Sheet, Yield Curve, Graphs from prior conversation..
https://www.biggerpockets.com/forums/311/topics/28...
@George GammonGreat link!
My guess is that long term negative rates will not have a huge effect on residential OO real estate. The whole reason for the negative rates is a weak middle class with diminished earning/spending power, with no more Fed firepower to help out. That same middle class is not going to be rushing out and splurging on McMansions any time soon.
On the investment side, I believe long term negative rates will boost prices at first but settle over time. The initial boost will come as people watch their stocks and bonds decline from negative rates and a weak middle class economy, and look to take charge of their nest eggs. Investment real estate is a natural fit and low interest rates will boost lending. As millennials are weighed down by student debt, auto loans and fewer/worse jobs, they will increasingly turn to renting as they did in the last recession.
But over time all the new real estate capital will have been deployed. Plus commercial non-residential will slowly decline for the same reasons as the rest of the economy, and residential investment properties can't get too far out of whack from residential OO. So the boost will not last forever.
Of course all of this is total speculation, but as WB himself said, this has never happened before and all anyone can do is to speculate. Do you have any quant data to provide insights, like you provide on local housing markets?
On the subject of WB, I just read his new annual letter to shareholders and he made the point that America's GDP growth is not in question. What people are arguing over, and will continue to argue over, is how that GDP pie will be divided.
This is a great point but I feel he is missing the permanent structural changes in the economy due to automation and increased globalization which are permanently benefiting the capital owning class at the expense of the economy as a whole. As a real estate owner I feel this is a good thing but as a member of society I know it is not.
@George GammonGreat link!
My guess is that long term negative rates will not have a huge effect on residential OO real estate. The whole reason for the negative rates is a weak middle class with diminished earning/spending power, with no more Fed firepower to help out. That same middle class is not going to be rushing out and splurging on McMansions any time soon.
On the investment side, I believe long term negative rates will boost prices at first but settle over time. The initial boost will come as people watch their stocks and bonds decline from negative rates and a weak middle class economy, and look to take charge of their nest eggs. Investment real estate is a natural fit and low interest rates will boost lending. As millennials are weighed down by student debt, auto loans and fewer/worse jobs, they will increasingly turn to renting as they did in the last recession.
But over time all the new real estate capital will have been deployed. Plus commercial non-residential will slowly decline for the same reasons as the rest of the economy, and residential investment properties can't get too far out of whack from residential OO. So the boost will not last forever.
Of course all of this is total speculation, but as WB himself said, this has never happened before and all anyone can do is to speculate. Do you have any quant data to provide insights, like you provide on local housing markets?
On the subject of WB, I just read his new annual letter to shareholders and he made the point that America's GDP growth is not in question. What people are arguing over, and will continue to argue over, is how that GDP pie will be divided.
This is a great point but I feel he is missing the permanent structural changes in the economy due to automation and increased globalization which are permanently benefiting the capital owning class at the expense of the economy as a whole. As a real estate owner I feel this is a good thing but as a member of society I know it is not.
Nick, thanks for the response. I totally agree with most of what you're saying but I see it from a little different angle.
1. The reason the fed lowers interest rates is to pull more spending into the present from the future. They're all Keynesian economists, therefore believe spending is the cure for all economic issues. How much more spending could they possibly pull forward? How many people have been saying "as soon as interest rates go negative I'll start a new business, hire more employees and buy a new house!"? I'm guessing zero. Essentially we're saying the same things.
2. Yes. If I had to make a bullish argument for inflation adjusted home prices rising it would be due to capital flows rotating out of cash to avoid paying interest on deposits or just chasing yield because negative interest rates pulling down returns even lower. My big concern there is that would incentivize people to go further and further out the risk curve. Generally that ends badly. The millennial situation is certainly bullish for rents. Although if the negative interest rates don't keep the economy from deleveraging employment rates might go up substantially even with these crazy labor force participation numbers. You're main deflationary risk with rentals is always population decline in the city or nieghborhood where you have rentals though.
3. Seems very probable. I submit Japan
4. My favorite chart is always the historic inflation adjusted home prices.
Here are some observations I made on another post...
First, notice that every RE decline has needed less of an interest rate hike as a catalyst (1980/8%, 1990/2%, 2008/1%). This makes sense because the amount of credit in the system has been exponentially higher at each point in time. This provides a very bearish case for US RE prices if interest rates on the 10 year go up modestly. Second, envision an approximate historic average. Looks like it would be around 135. Notice where RE prices fell when the market finally bottomed in 2012...just about 135. I don't think this is coincidental. It's obvious the rising prices of 2002-2006 were a result of expanding credit not increasing real incomes. Naturally when there's a deleveraging you'll have a reversion to the mean (where home prices should be based on real incomes). So then the question becomes where are we now? Definitely not to the 2006 highs but far above the mean. If you look at real wage growth, or lack thereof, it becomes obvious that this recent rising of real estate prices is a result of something other than real wage growth, which implies prices are artificially high again. Housing prices haven't "recovered" they've "reflated". The great news is it gives us a good proxy on where to start buying if/when prices come back down.
5. Personally I don't put much weight into that. I think he really has to watch what he says about the american economy for political reasons and since his views are so scrutinized by the public/media. Our economy is so reliant upon the expansion of debt, confidence is paramount. I think he knows that, and realizes his influence over that public confidence.
6. Totally agree about the real issue being structural...I see different structural issues being more problematic though. I believe the biggest issue is overall debt. See chart below of overall debt to GDP. The capital owning class always is the biggest beneficiary of asset inflation caused by the fed.
Real estate is tough to beat ;)
Thanks again for the response,
George
Negative rates will have an effect on home prices. For example, if you can afford to pay $1000 a month on your mortgage, at 6% that would be a 170k house, at 4% that is a 210k house. As a result people will spend more on the house. The thing we have to remember is that interest rates are not the only factor here. There are still cities selling off distressed homes at low prices and communities that have yet to fully recover from the housing crash. Personally I think prices in some areas areas still have room to grow.
Negative rates will have an effect on home prices. For example, if you can afford to pay $1000 a month on your mortgage, at 6% that would be a 170k house, at 4% that is a 210k house. As a result people will spend more on the house. The thing we have to remember is that interest rates are not the only factor here. There are still cities selling off distressed homes at low prices and communities that have yet to fully recover from the housing crash. Personally I think prices in some areas areas still have room to grow.
Solid points, I'd point out the following.
1. Very true. But how many people have the money for a down payment and haven't purchased yet due to interest rates being too high? Again, I'm concerned about demand decreasing going forward counter balancing the upward pressure neg interest rates should have. Lowering interest rates, QE etc. empirically has diminishing rates of return. I see demand possibly increasing from the investment side due to reasons stated above.
2. Interest rates are not the only factor going down but they would be the only factor that mattered going up ;)
3. I hear what you're saying but I'm leery. Prices going up due to a further expansion of credit (unsustainable) I don't like, prices going up because of real wage growth (sustainable) I do like...I don't think anyone would argue prices are/have gone up due to the later. The Nasdaq had room to grow in 1999, so did housing in 2005.
Those are some of my thoughts.
Thanks again for the post.
George
Negative rates will have an effect on home prices. For example, if you can afford to pay $1000 a month on your mortgage, at 6% that would be a 170k house, at 4% that is a 210k house. As a result people will spend more on the house. The thing we have to remember is that interest rates are not the only factor here. There are still cities selling off distressed homes at low prices and communities that have yet to fully recover from the housing crash. Personally I think prices in some areas areas still have room to grow.
Solid points, I'd point out the following.
1. Very true. But how many people have the money for a down payment and haven't purchased yet due to interest rates being too high? Again, I'm concerned about demand decreasing going forward counter balancing the upward pressure neg interest rates should have. Lowering interest rates, QE etc. empirically has diminishing rates of return. I see demand possibly increasing from the investment side due to reasons stated above.
For the most part I agree with you but I do have issue with point number 1. Rates have been low since 2012. The people waiting on rates would have bought long ago. The people buying today are buying because either they finally saved up enough for a down payment, they think prices are on the way up or because they are in a place now to buy (e.g. starting a family). Low rates will have little influence on them purchasing a house since like you said, they would have bought long ago. The fact still stands though that when qualifying for a loan the bank will tell you, you can qualify for X loan amount, and that loan amount is influenced by interest rates as they affect your monthly payments. People armed with a higher loan approval due to lower rates will spend more on a house.
@Gloria Mirzathere's absolutely no question that lower interest rates mean lower monthly payments. Lower monthly payments increases purchasing power, which in turn, puts upward pressure on prices. And of course the opposite is true when rates go up. Interestingly enough though it doesn't always play out that way in the market place.
I just noticed this the other day. Look at the chart of housing prices again.
And now check out a chart of the 10 year treasury (loosely tied to mortgage rates).
You'll notice, that at times, prices don't solely go up or down based on lower or higher monthly payments due to interest rates. There's obviously a lot of noise but it seems what might matter most is where prices are at the time of the interest rate move (at least since we left the gold standard in 1971)? That's by no means an opinion just thinking out loud. Also, it's odd that since leaving the gold standard the time between cycles has increased and we've had higher highs and higher lows. I'm not sure if that means anything but it's interesting...
Thanks for the feedback,
George
Way back when in my finance courses I remember a few key lessons on how valuation happens. One is to start with a "risk free rate of return", usually the rate on US treasuries, and add on a "risk premium" to compensate the investor for the risk they are taking. Well, if the "risk free" treasuries turn out to be not so risk free and in a bubble, and every single investment asset is priced this way, who knows what will happen since the very foundation for pricing is not at all stable or predictable.
Second is the net present value calculation, and how your cost of capital in this equation effects value. You can make the value of just about anything that produces cash flow go up to nearly infinity if you assume a low enough discount rate ... I think WB even alluded to this in the interview. But what happens when that discount rate goes up? BTW, I hear you about being a contrarian and feel the same way, but I respectfully disagree that deflation is a "crowded trade" so to speak at the moment. Yes there is a lot of chicken-little talk (which may end up being true) but I see more talk than investment dollar flow to back up their convictions.
Finally, I'm interested in poking a bit at your leverage strategy (50/50 debt/cash). Personally, I would think that free and clear (with cash reserves, of course) is the safer bet, but lower potential return. Free and clear RE is the only thing I can think of that would be ok under hyper-inflation OR deflation AND still perform reasonably well if neither occur. I could see how cash and fixed interest debt could hedge your bets, but also increase your operating expenses and risk in a potentially highly volatile environment. I do not see how even high quality RE would offer much liquidity in a tumultuous environment ... beautiful mansions in Beverly Hills could not easily be sold even at steep discounts in 2008. On the other hand, that extra "dry powder" in hand would come in handy so likely higher reward too.
@Gloria Mirzathere's absolutely no question that lower interest rates mean lower monthly payments. Lower monthly payments increases purchasing power, which in turn, puts upward pressure on prices. And of course the opposite is true when rates go up. Interestingly enough though it doesn't always play out that way in the market place.
I just noticed this the other day. Look at the chart of housing prices again.
And now check out a chart of the 10 year treasury (loosely tied to mortgage rates).
You'll notice, that at times, prices don't solely go up or down based on lower or higher monthly payments due to interest rates. There's obviously a lot of noise but it seems what might matter most is where prices are at the time of the interest rate move (at least since we left the gold standard in 1971)? That's by no means an opinion just thinking out loud. Also, it's odd that since leaving the gold standard the time between cycles has increased and we've had higher highs and higher lows. I'm not sure if that means anything but it's interesting...
Thanks for the feedback,
George
When the housing bubble burst the fed started dropping the fed funds rate in order to help lessen the blow of the housing market crash. That's why home prices were dropping while rates drop. Like we said, it's just one of the factors that effect home prices :-). Other factors are bubble inflation/burst, unemployment rate, stock market, generational trends.... If it were easy to explain where home prices are going we would all be rich!
Way back when in my finance courses I remember a few key lessons on how valuation happens. One is to start with a "risk free rate of return", usually the rate on US treasuries, and add on a "risk premium" to compensate the investor for the risk they are taking. Well, if the "risk free" treasuries turn out to be not so risk free and in a bubble, and every single investment asset is priced this way, who knows what will happen since the very foundation for pricing is not at all stable or predictable.
Second is the net present value calculation, and how your cost of capital in this equation effects value. You can make the value of just about anything that produces cash flow go up to nearly infinity if you assume a low enough discount rate ... I think WB even alluded to this in the interview. But what happens when that discount rate goes up? BTW, I hear you about being a contrarian and feel the same way, but I respectfully disagree that deflation is a "crowded trade" so to speak at the moment. Yes there is a lot of chicken-little talk (which may end up being true) but I see more talk than investment dollar flow to back up their convictions.
Finally, I'm interested in poking a bit at your leverage strategy (50/50 debt/cash). Personally, I would think that free and clear (with cash reserves, of course) is the safer bet, but lower potential return. Free and clear RE is the only thing I can think of that would be ok under hyper-inflation OR deflation AND still perform reasonably well if neither occur. I could see how cash and fixed interest debt could hedge your bets, but also increase your operating expenses and risk in a potentially highly volatile environment. I do not see how even high quality RE would offer much liquidity in a tumultuous environment ... beautiful mansions in Beverly Hills could not easily be sold even at steep discounts in 2008. On the other hand, that extra "dry powder" in hand would come in handy so likely higher reward too.
Speaking of inflation, everybody is afraid of it but when it comes to inflation, I think it would help a lot of people. Imagine having loans for 4% on real property with an inflation rate of 5, 6, or 10%. In real terms your actually getting paid to borrow the money. At first it would be a shock to home prices as people have less purchasing power due to high interest rates/inflation, but eventually the market would stabilize and home prices would keep up with high inflation, all while you're only paying 4% for the borrowed funds.
Way back when in my finance courses I remember a few key lessons on how valuation happens. One is to start with a "risk free rate of return", usually the rate on US treasuries, and add on a "risk premium" to compensate the investor for the risk they are taking. Well, if the "risk free" treasuries turn out to be not so risk free and in a bubble, and every single investment asset is priced this way, who knows what will happen since the very foundation for pricing is not at all stable or predictable.
Second is the net present value calculation, and how your cost of capital in this equation effects value. You can make the value of just about anything that produces cash flow go up to nearly infinity if you assume a low enough discount rate ... I think WB even alluded to this in the interview. But what happens when that discount rate goes up? BTW, I hear you about being a contrarian and feel the same way, but I respectfully disagree that deflation is a "crowded trade" so to speak at the moment. Yes there is a lot of chicken-little talk (which may end up being true) but I see more talk than investment dollar flow to back up their convictions.
Finally, I'm interested in poking a bit at your leverage strategy (50/50 debt/cash). Personally, I would think that free and clear (with cash reserves, of course) is the safer bet, but lower potential return. Free and clear RE is the only thing I can think of that would be ok under hyper-inflation OR deflation AND still perform reasonably well if neither occur. I could see how cash and fixed interest debt could hedge your bets, but also increase your operating expenses and risk in a potentially highly volatile environment. I do not see how even high quality RE would offer much liquidity in a tumultuous environment ... beautiful mansions in Beverly Hills could not easily be sold even at steep discounts in 2008. On the other hand, that extra "dry powder" in hand would come in handy so likely higher reward too.
Awesome post David, thank you.
I think Jim Grant said it well when referring to treasuries, he called them "return free risk" ;) It's so true though, price discovery is out the window when the cost of money, or one half of every transaction, is manipulated.
That's interesting...maybe it's just all the people I've been talking too? I've got to start watching CNBC again!
Great observations, you hit the nail on the head. Free and clear RE is absolutely the safest. It historically is a good store of value in any environment (if purchased at a price near its historical mean or if you can get it under cost of construction even better). So I try to throw a twist on that by pulling the equity out once I've paid cash. Assuming I can take out every dollar I put in, this gives me the 50/50 balance you mentioned. I've got my inflation/deflation hedge and I've got my equity out so I can't take a loss on principle and I can deploy it in the event of a downturn...that's the easy part.
The hard part is what to do with the cash once you've got it out of the property and back in the bank. It's endless risk/reward analysis...I'll ask myself "should I just sit on the cash and wait to see if the market corrects? That gives me the greatest degree of liquidity but then I have the opportunity cost of that cash not working. And then what if the market doesn't go down for 10 years?" or to your point "should I do a flip and put the money to work but then risk putting myself into an illiquid situation and is it wise to put the cash to work in the same market I'm waiting on to go down?" I'm sure all investors are feeling my frustration of the fed forcing you further out the risk curve.
That's the main reason I started investing overseas. I felt I was actually taking on less risk outside the US because of the crazy macro environment. I like RE markets with very little debt in them. Maybe it gives me a false sense of security? Only time will tell... ;)
Thanks again for the post,
George
Way back when in my finance courses I remember a few key lessons on how valuation happens. One is to start with a "risk free rate of return", usually the rate on US treasuries, and add on a "risk premium" to compensate the investor for the risk they are taking. Well, if the "risk free" treasuries turn out to be not so risk free and in a bubble, and every single investment asset is priced this way, who knows what will happen since the very foundation for pricing is not at all stable or predictable.
Second is the net present value calculation, and how your cost of capital in this equation effects value. You can make the value of just about anything that produces cash flow go up to nearly infinity if you assume a low enough discount rate ... I think WB even alluded to this in the interview. But what happens when that discount rate goes up? BTW, I hear you about being a contrarian and feel the same way, but I respectfully disagree that deflation is a "crowded trade" so to speak at the moment. Yes there is a lot of chicken-little talk (which may end up being true) but I see more talk than investment dollar flow to back up their convictions.
Finally, I'm interested in poking a bit at your leverage strategy (50/50 debt/cash). Personally, I would think that free and clear (with cash reserves, of course) is the safer bet, but lower potential return. Free and clear RE is the only thing I can think of that would be ok under hyper-inflation OR deflation AND still perform reasonably well if neither occur. I could see how cash and fixed interest debt could hedge your bets, but also increase your operating expenses and risk in a potentially highly volatile environment. I do not see how even high quality RE would offer much liquidity in a tumultuous environment ... beautiful mansions in Beverly Hills could not easily be sold even at steep discounts in 2008. On the other hand, that extra "dry powder" in hand would come in handy so likely higher reward too.
Speaking of inflation, everybody is afraid of it but when it comes to inflation, I think it would help a lot of people. Imagine having loans for 4% on real property with an inflation rate of 5, 6, or 10%. In real terms your actually getting paid to borrow the money. At first it would be a shock to home prices as people have less purchasing power due to high interest rates/inflation, but eventually the market would stabilize and home prices would keep up with high inflation, all while you're only paying 4% for the borrowed funds.
Fantastic point Gloria on fixed rate debt and inflation. I don't think most investors understand that strategy very well. Also, it's a big win on the equity if you're levered. Because the value of the home is more than the equity, you make an inflation adjusted return even if the price of the home is only keeping pace with the rate of inflation...
Speaking of inflation, everybody is afraid of it but when it comes to inflation, I think it would help a lot of people. Imagine having loans for 4% on real property with an inflation rate of 5, 6, or 10%. In real terms your actually getting paid to borrow the money. At first it would be a shock to home prices as people have less purchasing power due to high interest rates/inflation, but eventually the market would stabilize and home prices would keep up with high inflation, all while you're only paying 4% for the borrowed funds.
Absolutely right ... in fact, speaking of WB, he has also said that a 30 year fixed mortgage on high quality real estate is a fantastic way to short the dollar (bet on inflation) ... I seem to recall that he may have even used the term "no brainer" on that one. The flip side of that coin, though, is that if there is deflation, then you just borrowed cheap dollars and have to pay it back with progressively more expensive dollars, all while rents and the value of the RE that secures the loan also goes down in value ... if you are over leveraged and/or not hedged with an equal cash position as the OP wisely suggests, in that situation you could find yourself in the house of pain. To be fair, I think deflation would be temporary (it better be, or else invest in guns & ammo) and is a bit of a "black swan" event, but it is possible and I think more probable today than people are tending to give it credit for (my opinion and gut feel).
I guess inflation is a possibility with the fed funds rate close to 0 and the fed not having many "bullets" left to fight deflation if it occurs, but that's not really something that keeps me up at night. I'm more concerned with the world market crashes/corrections that are currently occurring and their ability to spill over to America. I'm in Silicon Valley and we are well above the housing bubble highes with prices supported by income and job growth. If/when we have a recession it's going to hit silicon valley hard.
Regarding silicon valley: I have no knowledge of the tech business capital structure but it seems any business that isn't cash flow positive would struggle if the cost of debt went up or what they could sell equity for went down? Maybe some additional risk to the local RE market?
David I recall that WB interview well. What worries me most about deflation is most investors are totally unprepared for it. At least with inflation, although not cognizant of it, their portfolios are inadvertently set up for it. On a positive note, I was looking at a chart of historic rents and it looks like they hold up well even when real prices decline, which makes sense because fewer people buying. Knowing housing price declines are a far cry from CPI deflation, I tried to find rent data that went back to the 1930's but didn't have any luck. I'm very curious to see what rents did then. If you happen to find any rent data going back that far please let me know.
@George Gammon , @Gloria Mirza, and @Nick L., great commentary.
With all this discussion of wages, home prices, interest rates, and qualification, I have to refer back to one of my favorite pieces of data that I haven't been updating lately: The Housing Affordability Index!
Here's some good historical HAI data I got together and analyzed mid-last year. I'll update it in not too long..
Scroll down a bit and look at how interest rates impact home price qualification. A lot of support came from decreased rates.
HAI from November: (courtesy of Paragon's Patrick Carlisle's work, with link:
http://www.paragon-re.com/Housing_Affordability_and_Market_Corrections )
INTEREST RATES AND RE CYCLES
In regards to George and Gloria's comments regarding the direction of interest rates and RE prices, I think we really need to differentiate the short term from the long term, and what is going on in the background. In the short term, increases in rates can cause all kinds of counterintuitive behavior (buyers buying more at higher prices expecting even higher rates). When rates are increasing over a cycle, it's usually because employment and lending conditions are improving, optimism improving, more cash on hand, oftentimes more than offsetting higher rates.
What I think we can say with a high level of certainty, is that in any given economic backdrop, lower rates would very likely cause higher prices, and higher rates would very likely cause otherwise lower prices. Imagine if the 30yr fixed mortgage rate was only 2.0% instead of 5.5-6.5% during the peak of the last market, with everything else (optimism, super loose lending, etc) the same (ceteris paribus as they say in econ...) My god!! Things would have almost certainly gone crazier. Conversely, imagine if, under the same circumstances, rates were 12%. Would things have been different? I have to say almost certainly, at least one home would have sold for less! lol
Inflation, Deflation, Fed Balance Sheet, Yield Curve, Graphs from prior conversation..
https://www.biggerpockets.com/forums/311/topics/28...
@George Gammon @David Faulkner@Gloria Mirza@J. Martin
What a great discussion! There's nowhere like BP for this sort of conversation. I wish I had joined years ago.
I want to introduce another factor, the psychological factor, and revise something I said before.
Earlier I said that OO residential RE would not see much change from a permanent negative interest rate environment. But thinking about it, house prices behave in positive correlation with interest rates when logically you would expect them to move in negative correlation. So I would actually expect house prices to fall.
When prices and interest rates move upward, people think "Better buy now while I still can!" When they move downward people think "Uh oh, better sell before it gets worse!" This kind of thinking is emotionally based and does not take into account affordability, price/rent ratio, net present value or other rational factors.
Per The Economist, "If you take the 24 years covered by the US data and divide them into three, then the average house price gain when real rates were high was greater (at 2.25%) than when real rates were low (1.7%)".
So how does this play out in a long term negative interest rate environment? Well in that environment you have to assume that the economy is also bad for the average Joe. So now your prospective homeowner has a crappy job, a ton of student/auto debt, and the ability to buy into a falling home price market. No thanks! He is going to carry on renting and OO residential units will fall faster than the deflation rate.
Here's another interesting thing that occurred to me the other day regarding Warren Buffet and what I perceive to be pricing irrationality in the investment markets: Berkshire Hathaway has been under performing lately, which is not at all usual as this company under Warren & Charlie's investment genius has consistently outperformed the S&P500 year in and year out. Some analyst are suggesting that Warren is too far past his prime and has lost his touch. I have a different take ... I believe that Warren is still the definition of skilled investing based on fundamentals and he will be yet again be proven right in the long run, even if it looks like he is wrong in the short term. If I'm right in that Warren is right, then his short term under performance may very well be due to short term irrational pricing in the markets more so than his losing his investing mojo. After all, another time he grossly under performed the stock market was 1999. Things that make you go "hmmm" ...
Speaking of inflation, everybody is afraid of it but when it comes to inflation, I think it would help a lot of people. Imagine having loans for 4% on real property with an inflation rate of 5, 6, or 10%. In real terms your actually getting paid to borrow the money. At first it would be a shock to home prices as people have less purchasing power due to high interest rates/inflation, but eventually the market would stabilize and home prices would keep up with high inflation, all while you're only paying 4% for the borrowed funds.
Absolutely right ... in fact, speaking of WB, he has also said that a 30 year fixed mortgage on high quality real estate is a fantastic way to short the dollar (bet on inflation) ... I seem to recall that he may have even used the term "no brainer" on that one. The flip side of that coin, though, is that if there is deflation, then you just borrowed cheap dollars and have to pay it back with progressively more expensive dollars, all while rents and the value of the RE that secures the loan also goes down in value ... if you are over leveraged and/or not hedged with an equal cash position as the OP wisely suggests, in that situation you could find yourself in the house of pain. To be fair, I think deflation would be temporary (it better be, or else invest in guns & ammo) and is a bit of a "black swan" event, but it is possible and I think more probable today than people are tending to give it credit for (my opinion and gut feel).
I agree with the inflation vs. fixed rate mortgages, which is why I've focused on them in the last downturn. However, I somewhat disagree that we will all end up having to pay the progressively more expensive dollars under deflation. (At least nor for long!) Huh? With every 30yr fixed rate mortgage comes an embedded option: the option to prepay the principal balance with cash, refinance, etc. into another loan. On conventional loans, they can't even charge a prepayment penalty for it! Even if rates do not go down, you could refinance to a variable rate, which is typically 75-150bp less (we'll see in the future). Or with deflation, I think most would expect low or lower interest rates.. This is assuming qualification, equity, lending. But probably not the craziest idea. So another option to refinance down..
So I see the 30yr fixed rate mortgage as an insurance policy. If you are a well-qualified borrower, you should have good odds of qualifying for something else if you don't like a potentially longer-term deflationary environment.
Some bigger fish like @Account Closedhave already prepared for a longer-term low-rate environment by taking advantage of low variable rates for a while now, and has been pocketing the difference. I gotta say, he has been right so far!! If I would have had one of those variable-rate 30yr am's I think you were recently talking about, I might have considered it! I think he and I probably agree on the general idea of the 30yr fixed rate as insurance since you don't have to stay in it forever. But unlike me, he doesn't think the cost of the insurance is anywhere near worth it! I think I'm drifting more and more into his camp.
I guess I shouldn't be too disappointed for each year my insurance policy does not "pay me out." But it does make me think about the cost of the insurance!! ;)
Speaking of insurance, Warren Buffet:
"Be greedy when other are fearful, and fearful when others are greedy."
While some people are talking about being cautious, I think their actions are saying otherwise, at least in Bay Area residential and commercial real estate (SF office.. wow! $6, $7/sq ft/mo rents for prime & rising.. ) Residential rents up 40-50%+ in the core bay all over. Prices riding fantastic appreciation. Overbidding like crazy (even considering intentionally low list prices). Many multiple offers w/ no contingencies or appraisals needed, and miniscule days on market. Actions say that others are being greedy, IMHO.
I see what you are saying @J. Martin, but that assumes that you will be able to refinance when the SHTF ... if that turns out to be true, I personally would rather be free and clear with unfunded HELOCs already setup on all my properties. If I were single, without kids, and your age, I'd probably do exactly what you are suggesting and presumably doing, though ...
@Gloria Mirzathere's absolutely no question that lower interest rates mean lower monthly payments. Lower monthly payments increases purchasing power, which in turn, puts upward pressure on prices. And of course the opposite is true when rates go up. Interestingly enough though it doesn't always play out that way in the market place.
I just noticed this the other day. Look at the chart of housing prices again.
And now check out a chart of the 10 year treasury (loosely tied to mortgage rates).
You'll notice, that at times, prices don't solely go up or down based on lower or higher monthly payments due to interest rates. There's obviously a lot of noise but it seems what might matter most is where prices are at the time of the interest rate move (at least since we left the gold standard in 1971)? That's by no means an opinion just thinking out loud. Also, it's odd that since leaving the gold standard the time between cycles has increased and we've had higher highs and higher lows. I'm not sure if that means anything but it's interesting...
Thanks for the feedback,
George
George, first, I appreciate that you are looking at this and sharing it. Where did you get these charts from? Can you get the underlying data? I would love to have it!
Second, it looks like your housing price chart is inflation adjusted, just judging by it not being multiples higher than 100 today. However, it appears that your 10yr Treasury chart is not real interest rates (inflation adjusted). So you're seeing this massive pull on nominal interest rates during times of inflation, that don't show similar movement on the RE prices, because the increasing RE prices already got inflation-adjusted out.. No?
INFLATION SINCE 1947 (THE DATA I HAVE HANDY - 1000% MORE EXPENSIVE; 10x)
ANNUAL INFLATION
INFLATION AND RE PRICES: 1975 ON (DATA I HAVE HANDY FOR RE)
You can see that especially during the 80's there was a strong correlation between inflation and RE.. How about rates? Did they diverge from the rest significantly?
I see what you are saying @J. Martin, but that assumes that you will be able to refinance when the SHTF ... if that turns out to be true, I personally would rather be free and clear with unfunded HELOCs already setup on all my properties. If I were single, without kids, and your age, I'd probably do exactly what you are suggesting and presumably doing, though ...
I agree. And I also would like to be rich and beautiful, but look where I am in life!!! lol
("I personally would rather be free and clear with unfunded HELOCS..")
The 30yr fixed rate option (insurance) is good for me given my situation. If I had tons of cash and financial resources, I wouldn't worry about just going for some variable rate in my mix of the portfolio.
At the end of the day, no matter rates, prices, etc up or down, I NEVER have to refinance that mortgage or experience a change in mortgage payments for the next three decades. I have the option to go down if I want to switch to variable or a lower rate and qualify at that time. Or Not! But I don't need to anyway. So I guess it helps me sleep well at night, knowing how much I leveraged to get here.. Someday, I will have less leverage like you and Minh. But I'm still growing into my fishbowl ;)
I am thoroughly impressed by this thread.
The trend is your friend. Deflation is a temporary situation, it can not last for any extended period. There are no long term examples, after wars, famine, government impropriety, etc it may occur. There are more people every year chasing the same limited resources, supply and demand will take over.
As long as the US maintains its high level of debt we will see fed rates well below below the rate of inflation. They can shrink the deficit by paying with dollars worth less than when they borrowed them. This will result in low interest rates on the 10 year T Bill, which drives the 30 year conventional mortgage. If you believe this as I do, then leverage is only sensible strategy. Since you will pay back the loan with cheaper dollars than you borrowed. Further, I would suggest interest only loans, since the net effect of the interest minus inflation would be negligible. For example, long term interest is in the 3% range and interest rates are currently under 4%. Who would not borrow money at a 1% net interest rate?
This is not to say that it is an excuse to be reckless and not maintain proper cash reserves. No one knows when the down turn will occur, but given enough time....
@Lesley Resnickthanks for your opinion, I'd like to respectfully point out a couple things...and please understand I'm not arguing for inflation/deflation, only offering food for thought.
1. Deflation is temporary and can't last an extended period of time. There are no long term examples? I think the 1930's may disagree...;) Joking aside, the dollar had more purchasing power in the year 1900 than it did in the year 1800...said another way, the entire century was net deflationary. In fact, the dollar doubled it's purchasing power. That means over that 100 year span we had 50% deflation. It may be a different world of fiat currency now but I'd submit Japan. 25 years of deflation while the population increased. And what would've happened 2009 if the fed would've done nothing? Most economists including Ben Bernanke thought we'd go into the worst deflationary depression since the 1930's.
But now we have far more debt in the system than 2009 and interest rates are already at the zero. It's a statement of fact that QE has diminishing returns and the returns on QE3 were negligible. The fed is out of bullets. What happens if we go into a recession with far more debt in the system and an impotent fed. If we faced something that looked like the 1930's in 2009, what are we facing now?
2. As long as US has high levels of debt the fed funds rate will remain well below inflation? To your point, the feds trying to create inflation to decrease real value of debt. What happens if they succeed? What happens if they can increase the velocity of money? Historically inflation is very hard to tame, and as we all know thanks to Paul Volcker, the only cure is interest rates above the rate of inflation. see chart
3. Interest only loans? does the reward justify the risk?
Thanks,
George
@George Gammon @David Faulkner@Gloria Mirza@J. Martin
What a great discussion! There's nowhere like BP for this sort of conversation. I wish I had joined years ago.
I want to introduce another factor, the psychological factor, and revise something I said before.
Earlier I said that OO residential RE would not see much change from a permanent negative interest rate environment. But thinking about it, house prices behave in positive correlation with interest rates when logically you would expect them to move in negative correlation. So I would actually expect house prices to fall.
When prices and interest rates move upward, people think "Better buy now while I still can!" When they move downward people think "Uh oh, better sell before it gets worse!" This kind of thinking is emotionally based and does not take into account affordability, price/rent ratio, net present value or other rational factors.
Per The Economist, "If you take the 24 years covered by the US data and divide them into three, then the average house price gain when real rates were high was greater (at 2.25%) than when real rates were low (1.7%)".
So how does this play out in a long term negative interest rate environment? Well in that environment you have to assume that the economy is also bad for the average Joe. So now your prospective homeowner has a crappy job, a ton of student/auto debt, and the ability to buy into a falling home price market. No thanks! He is going to carry on renting and OO residential units will fall faster than the deflation rate.
Nick, so true what your saying about behavioral economics...equally if not more important than everything else we're discussing.
I read a study the other day that shows people actually save more when interest rates go down. They don't get the return on savings so they have to save more to retire. I also heard David Einhorn point this out several years ago.
One thing I was thinking about that no one seems to discuss is the deflationary pressure lower interest rates could cause. Not saying they'd cause deflation but could produce downward pressure? Here's my hypothesis...Fed lowers interest rates which reduces corporate/biz borrowing cost. That reduces total cost of doing biz. Wouldn't a rational response be to lower prices to try to increase market share? If I had lower nut every month the first thing I'd do is lower prices to try to undercut my competitors. Everybody has lowering borrowing costs, so everyone starts to undercut. Lower and lower prices. Deflation as a result of lower interest rates...
Again, just thinking out loud.
George