Wednesday, June 23, 2004

Why Rising Interest Rates Will Hammer Housing

by Blanche Evans

For many areas around the country, buyers are way ahead of Alan Greenspan. Sales are already "flattening out" as the Fed chief predicts will happen, because buyers in many metros are beginning to assess their risk and deciding it's too high. Overheated housing markets such as San Diego are beginning to report mild rises in inventory and longer days on market, signals that the housing frenzy may be abating, while buyers' markets like Dallas are sinking further into apathy with every 1/8 point rise in interest rates as buyers decide that affordability is a bigger factor than opportunity.

New loan products and a relaxed lending environment, a lousy stock market, favorable tax laws and above average house sale returns, among other conditions have encouraged record homeownership to 68.6 percent last year. But many homeowners may get stuck in properties they can't sell if the nation sinks into a housing recession.

There are just as many factors on the negative side of the housing column to suggest that could well happen: rising interest rates, record consumer debt service, lack of real job creation, fears over terrorism and the coming election, to name only a few.

Every eighth of a point rise in interest rates impacts buyers' open-to-buy by adding as much as $25 or more per month to the monthly payment, depending on loan type. Consumer debt has reached 110 percent of disposable personal incomes. Despite a pace of three million new jobs created by year's end, unemployment figures are flat at 5.6 percent, if down from last year's peak of 6.3 percent. But, that figure is still 1. 6 million less than the number of jobs lost since 2001. Further, many new jobs don't pay what previous jobs did, according to the Economic Policy Institute. And, a 2.2 percent gain in earnings this year holds little comfort to those paying 35 percent more for a gallon of gas or double the price for a carton of milk, and eight percent more for housing nationally.

A primary but undocumented factor is the change in attitudes buyers have about homeownership. Homes, in the "new economy," are no longer a place to live, but an investment. Many homeowners have adopted a kind of daytrader mentality toward their abodes, flipping homes for hefty profits, using their bankers' money. Other homeowners have cashed out their equity to service other debts or to make improvements. Many have purchased their homes with so little down that they can't afford to sell except at an inflated price.

Never before has the home been such a crucial instrument of financial leverage.

The prevailing notion among sellers is somehow that buyers should pay them for having made such a clever investment. Further, sellers believe they are entitled to sell at a profit - they want to get paid for occupying the home, even if it was for a short amount of time and their largesse is due to bankers' goodwill. Making no sense, but a factor, nonetheless, is that many homeowners who were burned in the stock market meltdown of 2000 believe they should be able to make those gains back with their housing investments. This is particularly true of retirees and empty nesters.

Since 1980, according to the National Association of Home Builders, "home prices on average have increased around five percent annually and have never shown an annual loss." In fact, the housing market has been so good over the last eight years, that many homes have appreciated as much as 40 percent on average.

No wonder sellers have come to expect profits on their homes. And that's the key word here - expectation.

But buyers have expectations, too. They expect to realize equity, too, and now they are being told by the nation's most powerful economists that housing appreciation is slowing, interest rates are set to rise, and that job growth will offset rising housing prices.

But for many the reality is different from the national statistics. Nationally, markets differ. California may be in a housing boom, but Texas is not. And booms turn into busts sooner or later.

With interest rates rising, home appreciation is expected to slow, according to National Association of Realtors' economists. Buyers will want to be rewarded for buying in markets where slowing or flat home appreciation means more risk to equity-building.

They not only don't want to pay the seller for occupying the home, they want some of that unrealized equity for themselves. They aren't as swayed by arguments that lending rates are at 30-year-lows as they have been, because interest rates have hovered at low levels for over six years. All they know is that they are paying a point more in interest than today than four months ago, and that alone should slow housing sales in many markets. Another point, and housing will come to a halt. Not only will housing become too expensive, but so will debt service on other debts.

If buyers are going to become homesellers one day, they want the same thing current homesellers have received for the last eight years - instant equity. But equity can only be built with rising home values over time, because all loan products pay interest to the lender with little or no reduction in principle for years to come. If housing values go flat, it takes more time to build equity, and with the average homeowner staying only four to seven years, that isn't enough time to step over a flat or declining market. And there is the risk that a future selling environment could call for homeowners to bring money to closing, as happened to many homeowners in the late 80s and early 90s.

Buyers may recognize the signs that, suddenly, the conditions that favored homebuying are beginning to lose their underpinnings. Rising interest rates, a rising stock market, advancing inflation, sluggish job growth are all present. The high hopes of many economists who say that housing won't be significantly hurt by rising interest rates and slowing housing appreciation, are gambling that job growth will outpace inflation, and so far there's no indication that is happening.

And then there's human nature. No one wants to buy high and sell low. To get buyers to buy in that kind of a market, they have to be convinced that their risk will be rewarded, and there are only a few ways to do that since the simple joy of homeownership is no longer enough to get investment-conscious buyers to take the plunge.

What rewards them are incentives to buy - discounts, concessions, and upgrades.

The best way to reduce risk, they may come to believe, is to do what worked for them in the stock market - sit on the sidelines to get a better deal. Deals may seem few and far between while interest rates rise, reducing affordability and the range of qualifying loans, and while sellers hold on to high prices.

That leaves buyers no choice but to pressure sellers to give up some of the inflationary increases in their home values over the last few years. Buyers will put more pressure on sellers to reduce the price of their homes and to accept contracts with contingencies, along with ordering more repairs, and demanding more improvements.

The inability to build equity in a home means there is risk in liquidity, and that is the biggest factor to hurt housing sales. Housing and the stock market will change places as the stock market moves back in favor, and rising interest rates makes housing look less favorable. Just as stock buyers did in the stock market, housing buyers can afford to wait on the sidelines and buy on the dip.

Published: June 23, 2004


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