What Does “Tapering” From the Feds Mean to the Real Estate Market?

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It’s been just a few years since the near collapse of the financial system and the collapse of the housing market, and we now again have a stock bubble forming and housing prices edging their ways back to the old prices. Thanks to the Fed, who is once again pumping an insane amount of dollars to prop up all asset prices, we are entering the territory of the unknown.

The Feds knows that they are creating a bubble, but they are denying that it is the case. However, they are caught in their own trap. When they tried to talk about tapering back in May, mortgage rates spiked up and stocks fell. Mortgage REITS, which took in profit by borrowing short term and lending long term mortgages (S&L anyone?), fell precipitously and endangering the $400 billion industry. They are NOT going to be the one who’s going to hit the reset button. Rather, they are going to wait for the market to crash and then say “Hey guys, we had no idea it was a bubble,” repeating the same old Greenspan play.

What Could Happen?

Let’s just say, for the absolutely unlikely event that the Feds will taper, we will see an end to low interest rates in the mortgage market for sure. The private market is going to have to come back in and come back in strong. Someone is going to have to fill that $85 billion a month gap. And they are expected to get paid for the risks. Mortgage REITs that borrowed short and lend long will be forced to raise their rates as well or else their business will liquidate.

The housing market is going to take a big hit from the rise in the mortgage rates. Already, the May episode has already bumped mortgage interest rates up to a point where most homebuyers stopped paying for houses and homeowners stopped refinancing. The housing market has clearly slowed down the past several months and as of right now shows no signs of regaining the past momentum. Unless you are a hedge fund or an overseas investor loaded with cash, chances are most people cannot afford higher rates.

If demand goes away, prices will ultimately fallIf prices fall again, many homeowners will be tempted to default again. Even those who are now deciding to keep their house might just finally let go. We may see another collapse in the housing market again.

Knowing that, the Feds are not going to stop the purchasing. They are just kicking the can down the road to avoid the inevitable. There will always be talks about tapering. But I don’t think the Feds will be the ones doing it. The market will one day stop this madness but for now, the ideal play is still to lock in a home with reasonable rates of mortgage. The housing market may collapse again, but if you hold a 4.5% 30-year mortgage when the market rate is 7-8%, you’ve still hit the jackpot.
Photo Credit: Medill DC

About Author

Leon Yang

Leon Yang is an active real estate investor in Las Vegas. He is a buy and hold guy who also likes to flip from time to time. His main passion is to traveling to the less traveled places and inspiring others to become financially independent through real estate.

28 Comments

  1. Nice article Leon,
    I am still seeing a wry string market where I am. I think rates are higher, but they are still incredibly low compared to historic rates. The thing that I see is the lacking inventory in the low end still. The builders can’t build cheap enough to meet the low end or even middle/median price points. Because of that the is a lack of supply. For years the low end depended on Reo ad short sale for supply, now that has dried up. I personally don’t see a slow down coming anytime soon in my area.

  2. Michael Woodward on

    Thanks for the article Leon! It’s always very difficult to predict market direction so I try to absorb as many different points of view as I can to develop a big picture view. Hopefully you’ll get a lot of responses here so we can see what the consensus is.

  3. Leon, spot on. Taper or talk of taper means higher rates. And we are not even talking about stopping QE which was introduced as a temporary measure!

    Question for you, when asset prices fall, the investor will lose your equity in his investments. How will one handle that? Will the rents go up?

    • Abdul,

      Yes, when asset prices drop the investor’s equity drops, as well. How will one handle that, depends on variables. As we’ve seen from the previous 2008 collapse the residential sector was hit severely. Thus, many displaced homeowners had to transition from owning to renting. Rent went up as a result of high demand. But this does not necessarily have to happen again should we experience another real estate deflationary event. I say that b/c since 2008 there has been a large increase in the supply of rentals (many builders who survived the crash shifted their building from residential to multifamily). This means that in many areas rental supply has met or exceeded demand. When supply is more available then competition for rents creates a drop in rental prices.

      Another factor is what could potentially happen should the natural market forces (which are now geared towards an interest rates correction) would unleash such event, one as mentioned by Leon in his article? Today, we have builders, developers, and large R.E. investors who have secured temporary short term loans at low rates. If a large enough number of these borrowers are caught in a phase of a substantial rate increase, their exit strategy could be compromised. In other words, the majority of real estate investors rarely understand macro-economics, that’s why many of them suffered substantial losses in the past. Austrian Economists (which are the free market economists) have established that during times when rates are suppressed (via monetary inflation of the central bank, the Fed in our country) malinvestments occur. Which means many businesses and investors proceed with enterprises/investments that under normal circumstances (meaning when rates are at their market dictated levels) would not be profitable. Malinvestments are the first evident in a deflationary event and the first to fail. So, my point with this, is that we could see builders, developers, rehabbers of multifamily properties not having the ability to refinance their temporary loans. If a substantial number of projects cannot be refinanced and thus foreclosed, a commercial real estate deflationary event could potentially occur. Foreclosures could shift the balance of demand/supply ratio to where again rental values could go up.

      There are many variables, some easy to see and some not that easy. For an investment to be profitable I’d say one must take in consideration not just the price at which is bought but the nature of the leverage he acquires.

  4. Jeff Brown

    Some relatively recent history to consider. In the 70s and again in the 80s, real estate values rose significantly, and demand remained measurably strong with rates that were never, without exception, below 7%. In fact, much of the time the rates were in the 8s and 9s. The difference now, of course, is the overall job picture, which is a very bad joke today, especially when compared to those two examples.

    • Jeff,

      You are correct when bringing up the real estate uptrend during the stagflation of the 1970’s and Volker’s contraction of the money supply which lead to a prime in the 20’s percent. My belief however is that today we’re in a different economic environment. During the 1980’s we were the world’s largest manufacturing and creditor nation. Today we are the largest debtor nation. Three decades ago the economic correction came via government’s smart decision (albeit only temporary) to step back from market interventions by allowing the private sector to take its entrepreneurial course. Today, we are not even close to that, we are dangerously far away (think govt take over of the banking industry, Fannie & Freddie, healthcare, agriculture via govt subsidies, etc.). Add to that price inflation which is always the result of monetary inflation. In a nutshell, cost of living goes up, people’s incomes don’t go up at the same pace and levels, thus a lower standard of living. Real estate prices are commensurate with people’s ability to buy, so their purchasing power is diminished due to price inflation and lower wages. Unlike, the 1980’s we’re not seeing any effort from the government to refrain from market intervention. Contrary, they still think that pouring newly created money in the economy would revive it. The definition of insanity over and over since 2008.

        • Thanks Jeff, I agree with you. Yes, jobs is what we’re lacking. I, for one, have much more faith in the jobs provided by the private sector than jobs provided via the government sector or through subsidies. Sadly, the private sector has been strangled with government imposition of regulation, unfair taxation, and protectionism. Cheers;-)

    • Jeff,

      You must not have lived in the same 70s and 80s as myself. I took a look back at the unemployment stats to see who is right. Unemployment was higher than it is now from 1975 into 1977. Then again it was higher except for a couple of months all the way from 1980 through 1985. Look it up on the BLS.

        • You can argue the measurements are different, which may be true. However, no sane person can argue there is more unemployment now than in the horrible recession of 1981-1982, when the listed unemployment rate was 10.8%. It was truly terrible then. With the 24 hour cable news now, the current economy is only made to seem worse, but to those of us on the ground, it ended a long time ago.

          As an aside, I live and invest in Los Angeles. CA is berated in the national press as having a terrible economy. This is true, despite the booming tech industry in Northern California, which means Southern California is seen to have an especially weak economy. Yet, just last week, rents were reported to be 6% over the peak reached in the boom in 2005-2006, which is what I am seeing in my properties.

          My phone is ringing off the hook with job openings and I am not even looking to switch. Granted I am in an in demand position, but this is the most demand I am seeing since the mid-2000’s and friends and colleagues are reporting the same.

          If this is what life is like in what is perceived as one of the worst performing states in the worst recessesion since the 1930’s, I’ll take it all day long.

        • Hi Matt, I’m really delighted to hear that your neck of the woods is so bright and that you’re doing so well. Even more reasons to be cautious because what you’re describing might very well be the bubble that will burst. The higher and faster the real estate prices move the more pronounced the deflationary process when the market corrects itself. And it will. The question is when. I don’t wish to see R.E. prices drop but I can’t control the forces of the market. Cheers.

          P.S. By the way, just cause your local economy is doing well employment wise, it is not an indicative of the entire country. Case in point why we have more than 50% of the population on govt. benefits.

      • Jeff Brown

        Apparently, Matt, SoCal was living a different experience back then. Not only did real estate skyrocket, but folks were buying and paying for homes at an historic rate, and at much higher interest rates than today. From 1975 to 1981 prices nearly tripled, ending with a $100k median price. I suspect our defense jobs, and military presence had much to do with that. Not only that, but the investment property in SoCal was selling at a far higher rate than had been seen since the end of the war.

        Where SoCal got hit harder than most with unemployment, especially San Diego County, was years later during the S&L Crisis. We lost two of the five biggest employers virtually overnight. The financial and economic destruction was terrible.

  5. What indication do you have that we are in a bubble, or that the Fed knows that we are in a bubble? There is significant uncertainly regarding this, even among leading economists.

    I think there is not doubt in anyone’s mind that the Fed will reduce the buying programs at some point, the question is when. I’m sure there will be some market reaction, but I doubt it will be catastrophic.

    If interest rates rise, prices will probably slow or fall to some extent. However, isn’t your strategy based on appreciation? If that’s the case, what are you doing to prepare for the disaster you predict?

    • Adrian,

      I’m in the commercial lending industry, I see in many areas cap rates which at today’s low rates are not healthy, they are too low, which means the asking price is too high. To give you an easy to understand example here is an apartment complex, say in a city in California. It’s for sale and comes with a cap rate of 4.5%. Someone buys it but unlike residential loans the borrower cannot get a fixed 30 year term loan (unless it’s a HUD loan but that is not the norm today). The building’s debt coverage ratio is at the very minimum, the standard 1.2, and this is based on today’s low rates. If that rate were only half a percent higher the building would not qualify for the loan. OK, fast forward, five years down the road, when the loan comes to maturity, the loan must be refinanced and the rates are at 6 or 7 %, just about 2 to 3 points higher than today. Will the building qualify to refinance? Variables will dictate that but my point is that when cap rates and DSCR are so low it tell me the prices are higher than where they should be.

      Now, if you go to Detroit you won’t find the low cap rates. Of course, local economy will also have a major impact on the pricing of real estate.

      Austrian economists have predicted the real estate bubble early enough. Peter Schiff is a student of the Austrian School and here is a 2006 video when he had foreseen the real estate bubble at a Banker Association conference. If you have the time, I think it’s worth watching it. https://www.youtube.com/watch?v=jj8rMwdQf6k

      Finally, there is a bubble in real estate. From an economic standpoint monetary expansion induces asset artificial inflation (it’s seen in the equities market, the bond market, the real estate market, the student loan market). But I am more concerned with, is in what stage of the bubble are we, how close are we to another burst, how could the fed’s rate suppression and its forecast of tapering vs non-tapering impact my investment, is there evidence of a potential banking crises which could trigger the bubble to burst? Have I bought at a low enough price, have I stabilized the property to maintain high occupancy levels, have I secured as long as possible fixed rate financing? I can’t change an economic event but answering all of the above questions would put me in a better position, I think.

        • Hi Ben,

          There are many stupid people buying apartment buildings with plenty of deferred maintanaince at half that cap rate (2%) in downtown Vancouver, Canada, the real estate bubble capital of the world.

        • Hi Ben, sorry for the late reply, Thanksgiving holiday was something worth taking the time away from the computer.

          There are less buyers in this cap rate than there are in the higher. The problem I believe is that buyers, and especially less experienced ones, still count on price appreciation when making offers on properties with high cap rates.

  6. Don’t worry the Fed is never going to taper, if it was to stop printing the interest rates would soar. Problem with higher rates would be the impossible cost to pay the interest on the National Debt. Tapering could only happen in a growing economy, that is one that is not growing soles based on printing money as ours is now. Without growth there is no place to gain tax revenues to pay the extra interest.

    Only way out of this mess I could see would be if the USA became a net exporter of all that natural gas and oil we are fracking out of the ground. Then maybe we could balance the trade deficit.

    What would happen to most of our rentals if our tenants had to pay higher interest on their debt? Figuring most all Americans live in a fantasy world of debt that underwrites their life styles. What if the interest rate ticked up to 8% who could buy a house at the present pricing? Not many so prices would have to drop, not going to happen. If prices of housing dropped with higher interest rates, most municipalities would be dealing with property tax reduction. No way is tapering ever going to happen, the cat is too far out of the bag.

    Everything will reset when the boat goes over the falls, lots of people will lose everything, and we can start over with something like Bitcoin.

  7. http://pragcap.com/understanding-quantitative-easing
    I think there is a lot of misinformation regarding how QE works and what it is actually doing. Here is an article that explains is a lot better than I can, although I will say that QE is not money printing but better described as an asset swap, not adding financial assets to the private sector.

    I do not not believe the FED will actually taper anytime soon but will keep it in discussion so the market stays aware of the eventual taper. The stock market is over bought and cyclically the US economy will enter recession within the next 18 months although I believe it will be mild. The households in the private sector are not strong enough to drive economic growth at this time and we will continue to need fiscal policy assistance in conjunction with a shrinking trade deficit. The households are still over leveraged and while they have made a lot of progress they still have a way to go and will most likely over correct before sustained growth will take hold. One very interesting factor is the population dynamics at play with boomers retiring, I believe the transition will be a little painful as all large change is but has the potential to be very beneficial going forward.

    • Hi Kyle,

      Thanks for the article you submitted on the QE explanation. I appreciate your contribution. When I have a little extra time I will attempt to discuss it b/c so far, it’s very interesting and it may need further clarification. It is written in terms which are not used in common day language.

      In the meantime it would be great to get your feedback from a short article recently written by a former Fed member. Here it is:
      http://online.wsj.com/news/articles/SB10001424052702303763804579183680751473884
      Cheers!

    • Hi Kyle,

      I’m back after reading the article you posted a few days ago. QE is a powerful means of increasing the money supply. I found the article you posted being flawed for several reasons.

      The author claims that “it’s best to think of QE as an asset swap that alters the composition of the private sector’s financial assets, but does not ADD net financial assets.” What he does not mention is:

      1. Where does the Fed get the money to buy the Treasuries from banks and non-banks? The answer is: it’s created out of thin air. It’s true they don’t print the dollar bills like they used to in the past at the Bureau of Engraving and Printing, they add zeros to the computer ledger. Nevertheless, the money supply has been increased. Here is proof.
      Check this chart from the Fed’s website: http://research.stlouisfed.org/fred2/graph/?s%5B1%5D%5Bid%5D=AMBNS

      2. When the govt needs money the Treasury Dept issues debt (IOU’s) which is a promise to pay the debt holder so much money at such and such time. It is backed by nothing. The parties who buy the Treasuries in the Open Market (whether banks or non-banks banks) pay a price for these assets (Treasuries), which means the govt is using this money to pay for the expenses that are not covered by income tax collection.

      3. The banks are used as intermediaries. They buy treasuries from the govt and they sell them to the Fed. The Fed earns interest on this debt. However, why the Fed has no money to pay for the Treasuries when it buys them (and thus resort to creating new money) is because at the end of each year all the income (after it pays its expenses) is returned to the govt. So the govt collects money upfront when it sells the IOU’s and at the end of the year when the Fed pays most of the interest that was earned (paid by the govt itself). Pretty clever, isn’t it?

      4. The sellers of Treasuries (whether banks or non-banks) deposit the money from the Fed in the banks. Under the fractional reserve banking system, the banks could lend 90% of this newly created money to people and businesses. So, we’re not seeing major inflation because banks are not lending. If the banks would start lending major inflation would cause severe problems. Because they are not lent out, the banks keep them as excess reserves. Here is the Fed’s chart showing the mega increase of the excess reserves of the banks starting 2009 when QE became the govt solution to the economic problems. http://research.stlouisfed.org/fred2/series/EXCRESNS

      Here is an easy to understand description of how the QE works. I hope you enjoy it.
      https://mises.org/daily/4029

  8. Kenneth Estes

    Heya Leon,

    I ran across you out here on BP for the first time today and I’ve got to say you’re fast becoming one of my favorite authors. You’ve a solid reasoned approach to investing (no shortage of gurus out here).

    I did some analysis of home prices vs interest rates a while back and found that the correlation between the two is actually incredibly low. If you’re statistically inclined, we’re talking an R-squared of like .03 over the last 40 years.

    The fundamentals of high interest rates = lower home prices has an intuitive appeal, but doesn’t have any data to back it up. Certainly not when we’re talking interest rates as low as they are now. Things might change if we go over 15% again.

    It’s not a question of if the Fed will stop tapering…it’s a matter of when. The Fed’s ability to do so is entirely dependent on faith in the dollar. That’s fast eroding.

    Both those arguments are against some of what you have to say, but your conclusion still holds, if you get a fixed rate 30 year mortgage, all of the tail risk is on someone else’s plate.

    Cheers,

    Kenny

  9. Hi Kenny,

    I’ve been intrigued by the home price versus interest rate conundrum myself and have seen quite a few studies that back up the low correlation.

    However, I have seen rebuttals which demonstrate that many of the increases in interest rates occurred during periods in which median income was also rising, which offset their effect on home values.

    Obviously that wouldn’t be the case now. If you or anyone else has seen studies which combine these two factors in relation to home prices I’d love to hear about it.

    I work with dozens of homebuyers over the course of a year and every time rates go up we have to recheck our DTI ratios when placing an offer. Intuitively I find it hard to believe that any increase won’t produce a drag on values.

    Cheers,

    Derek

  10. Great discussion going on here.
    I wanted to comment to make sure I see anything else that comes up.

    The one thing I’ll contribute is to the thoughts that the FED might be knowing and willingly inflating a bubble. I don’t think that is the case, I truly believe they are oblivious and kind of dumb…

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