Will Rising Interest Rates Cause a Crash in the Housing Market?
Interest rates are going through the roof just in time for the Spring housing season, does that mean the market here in the Bay Area is finally shifting? The short answer to whether a market shift or collapse is coming to the Bay Area housing market is no. Especially not anytime soon. While many casual observers are seeing a housing bubble In the Bay Area much like prior to the subprime crisis in 2008, the reality is that the fundamentals now are completely different now than they were in 2008. Let’s start with supply and demand. In order for the market to reverse there will need to be some combination of a substantial increase of supply and a significant reduction in demand. To put into perspective where things are right now, let’s look at the absorption rate which is the best measure of supply and demand in real estate. The absorption rate measures the number of sales against the number of available properties in a given period, with any rate in excess of 33% generally defined as a seller’s market. In March, the absorption rate in San Mateo and Santa Clara counties for pended sales closed the first quarter at 128.3%, soaring to 175.2% in March. The last time the quarterly absorption rate fell below 33% in those combined counties was in 2011. As the absorption rate shows, a substantial amount of upheaval in the current market will need to take place to change the dynamics of the market. Given that, let’s take a look at interest rates. As of April 11th the average 30 year fixed mortgage rate sits at 5.25% according to Mortgage News Daily. That’s up over full point in just a month and marks only the second time the rate has exceeded 5 percent since 2011. The jump in interest rates has been swift and was triggered by a quarter point increase of the federal funds rate by the Federal Reserve in March. Buckle your seatbelts because the Federal Open Market Committee now expects to raise the rate at each of its six remaining meetings this year. So, are the rising interest rates enough to cause an upheaval in the market? There will certainly be an impact on the demand side, but let’s look first at the supply side where inventory is currently extremely low and has been trending downward. Year over year monthly inventory throughout the Bay Area has fallen 27 months in a row. Let’s compare with what happened in 2008. In 2008, there was an influx of supply that hit the market due to foreclosures and short sales and demand simultaneously dried up as subprime lenders collapsed and access to credit became harder. Mortgage rates throughout the 2000s were between 5 and 7 percent, much higher than they have been for the last decade, particularly recently where we have seen record lows within the last 2 years. In the 2000s risky adjustable rate mortgages with balloon payments were prevalent, they are not right now. In stark contrast to the last bubble, homeowners now are predominantly locked into fixed rate mortgages at record low rates as many have taken advantage of refinancing opportunities. Due to appreciation and enhanced lending standards, most homeowners now hold a substantial amount of equity in their homes. In 2008 many homeowners were underwater and facing balloon payments that they couldn’t afford. In contrast, today, homeowners have substantial home equity and are locked into mortgage payments that are well below the current market rate. In essence, many are locked into a standard of living that they wouldn’t be able to afford on the open market. With no external pressure to sell, the question becomes, where is the additional supply going to come from? Sellers who need to finance a new property will likely face paying rates 3 plus points higher than their current payment, plus the possibility of a large capital gains tax bill. In that aspect, the interest rates could potentially depress supply. Sellers moving out of the Bay Area to cheaper markets are the strongest candidates to sell, but that’s already the case. Same with sellers looking to downsize and use their equity to pay cash on their new property. Perhaps others could sell to gain access to liquidity given the high rates and investors could take advantage of 1031 exchange sales. Even so, a large increase in inventory doesn’t appear to be forthcoming. On the demand side, the people who are most impacted by the rate increases are buyers who need financing to enter the market or move to a more expensive house. These are precisely the people who are disproportionately losing out currently in bidding wars, and the rates may push these people out of the market, and perhaps out of the area completely. Some buyers looking to purchase second or third homes by taking advantage of low interest rates which was a feature, particularly during the pandemic will likely leave the market as well, those a good number of these buyers could choose to pay cash for these homes. While the exodus of these buyers from the market will soften it somewhat, given that supply is likely to remain extremely low, how much of an impact will it truly have? Investors who have been very active recently figure to continue to be active because real estate is considered a good hedge on inflation. On a broad scale, while I expect absorption rates to fall as interest rates increase and the pace of home appreciation to slow, I don’t expect there to be a major correction in the housing market. There’s simply too little supply and too much intrinsic demand here in the Bay Area. I do expect the market to soften, and potentially decline in some areas as a result of the interest rate increases. Areas of the Bay Area with lower general demand, particularly those where demand is high for second and third homes could soften. The condo market, which is already comparatively weak, is likely to soften significantly. Some areas in the East Bay which are the tip of the spear for entry level home buyers may also suffer from reduced demand. For buyers who are looking to get in the market, I strongly encourage you not to wait hoping for the market to crash. If you can afford to buy now, you should do so and get in the market before the increasing rates price you out completely. Interest rates are trending upward and will continue to do so for the foreseeable future. While today’s 5 percent rate doesn’t look good compared to the rates in the 2 percent range last summer, it is likely to look pretty good by the end of this year where rates could be in the 7 percent range. Sellers remain in the driver’s seat. Due to changing market conditions I wouldn’t expect the same rate of appreciation over the last few years, particularly on entry-level homes. If you have an entry-level home, now may be a time to consider selling as you’re close to the top of the market, but it depends on your cash position and your goals. If you’re thinking about leaving the area, now is the ideal time to sell in my opinion. At this point, if you sell, you will get a premium for your home.
Why is Bay Area Housing Inventory So Low?
Year over year housing inventory in the Bay Area has declined 27 months in a row. Why is inventory in the Bay Area so low? The downward trajectory of year over year inventory in the Bay Area predates the pandemic and goes back to the summer of 2019. It is the low inventory coupled with increasing demand spurred on by low interest rates that has led to the exploding appreciation in the housing market the last couple of years. There are several factors that have led to the reduced inventory. The pandemic and the prospect of selling and moving in the midst of COVID certainly eliminated the possibility of selling for some. Others thinking about selling who wish to stay in the Bay Area wanted no part of being on the buy side for a replacement property. The factor that nobody’s talking about is the capital gains tax triggered by selling a home that has appreciated at a rapid pace. Homeowners are able to exclude up to $250,000 in gains from the sale of their home from taxation, and $500,000 for married couples filing jointly. Because many homes have appreciated above those limits, selling the home could trigger a substantial tax bill that takes a big bite out of the proceeds. As an example, I have a client who bought their home for $950,000 in 2004. That home is now worth $3.3M. Even after the $500,000 exclusion, the taxable gain is $1.85M, taxable federally at 20 percent and at the top ordinary state rate of 13.3%. So one third of the gain, or about $610K in this example would need to be paid as taxes. That certainly makes selling less palatable, especially when there are alternatives. A strategy to at least delay paying these taxes is the 1031 exchange, and that’s what many sellers are doing, especially those who are in strong cash positions. One major catch is that primary residences are ineligible for 1031 exchanges, only investment properties are. How it works is that a seller would sell a qualified investment property and would need to close on a like-kind replacement investment property or properties of equal or greater value within 180 days in order to defer all capital gains taxes. In order to qualify a home for a 1031 exchange, it would need to be converted to an investment property, so the strategy involves renting the property out doing a cash out refinance for liquidity if needed. The property then generates cash flow and becomes eligible to be sold and exchanged for other properties after several years, or it could be held as a rental property. The net, short-term result though is liquidity in the form of a refinance and cash flow, the deferral of capital gains tax and a home kept off the market. As interest rates increase, this strategy could start to become less palatable if a refinance is needed for liquidity, but the 1031 exchange option indefinitely delays a large tax bill and eventually gives sellers the opportunity to invest in other areas of the country where their ROI is greater than in the Bay Area. The prospect of paying substantial capital gains taxes and not being able to maintain the same standard of living after selling are some key concerns that impact inventory. It is a factor that many people don’t consider when they ask why inventory remains so low when it’s such a great time to sell. If you’re thinking about selling your home, it’s absolutely essential that you understand the value that you want to get for your home and the tax implications involved with selling so that you protect your investment. It’s also worth noting that the Biden Administration is hostile toward 1031 exchanges. In its recent budget proposal, Biden included a rule capping the capital gains deferral to $500,000 for an individual or $1M for a couple. That, if passed, and rising interest rates may change the calculus for some. It’s somewhat ironic that the record appreciation that we’ve seen throughout the years in the Bay Area is stifling inventory, but the capital gains bill resulting from that appreciation has certainly given some sellers pause.
Rising Interest Rates and the Bay Area Housing Market
Mortgage rates are sharply increasing just in time for the Spring housing season, what will the impact be? Let’s start by putting into context where the rates are right now. As of March 30th, the average 30 year fixed rate sits at 4.79% according to mortgage news daily. That’s off from 4.95% from Friday March 25th, but still up over 3/4 of a point from the beginning of March, up 1.5 points since the beginning of this year and 2 points since last year’s low of 2.78% in August. To put things in historical context, rates right now are at their highest level since November of 2018. Before that, the last time rates exceeded 5% was in February of 2011. The increasing mortgage rates come on the heels of a quarter point increase of the primary credit rate by the Federal Reserve on March 17th, the first increase since December 2018. The Fed also revised its earlier projections of 3 rate hikes in 2022 and now anticipate 6 additional hikes this year to combat rising inflation. That means the days of historically low interest rates are now behind us. So what does that mean for the housing market here in the Bay Area? First time buyers and move up buyers in need of financing will be hurt the most. To put things into perspective, the monthly payment on the maximum conforming loan at current rates is $5,088. That’s a staggering $509 more expensive than it was just at the beginning of March, $842 more expensive than it was at the beginning of the year and an incredible $1,109 a month more now than for those who bought last August. Not only are loans more expensive now, it also becomes much harder to qualify for a loan because the increased monthly payments increase the debt to income ratios which lenders use to approve buyers for their loans. That means that the amount of money buyers can qualify to borrow is significantly less right now, which lowers their cap on the purchase price. At the same time, while rates have increased by 2 points since August, home values in the Bay Area have appreciated by 11.35 over that same span. What that means is that buyers who could have bought in August but decided to wait for the market to cool off, or to save for a bigger down payment will face a much more expensive purchase, and many may have been priced out of the market. As an example, if a house was available in August for a million dollars, a 20% down payment would have been $200,000 and the monthly mortgage payment would have been $3,279. Given average appreciation, that same home is now worth $1.113M, meaning the down payment increased by $22,600 and the monthly mortgage payment is now $4,666 – an increase of $1,387 per month on the exact same house. Additionally, there is the opportunity cost of $113K in equity, more than half of the down payment. Since housing prices are a function of supply and demand, will the rate hikes impact buyer demand enough to slow the market down? My answer for most of the Bay Area is no because inventory remains so low. The absorption rate is used to measure demand by dividing sales per month by the number of available properties. Generally speaking, an absorption rate above 33% is considered a seller’s market. In San Mateo and Santa Clara counties, the absorption rate was 143.4% in February. In order for the market to slow down, supply will need to increase and demand will need to fall off. Throughout the Bay Area, supply has been trending down since September of 2019. Inventory of single family homes in February was only 2,428, which was a 25% year over year decrease. In fact, year over year inventory in the Bay Area has declined 26 months in a row. While there are many factors why inventory is continuing to decline, the bottom line, is that even with an expected decline in demand due to increased interest rates, all the metrics point to the market continuing to be a very strong seller’s market and for home values to continue to appreciate as a result, though likely at lower rates than they have been over the last two years. To those expecting a market correction like the 2008 bubble, I don’t see that happening. The fundamentals of the market are different. Unlike in 2008 there aren’t a lot of bad mortgages out there and people hold substantial equity in their homes. While economic conditions may lead to some defaults, I don’t anticipate a large number of foreclosures or short sales either. In certain pockets, we may see markets emerge that are more favorable to buyers than has been the case. I expect that to start to happen on the San Mateo County Coastside where a good number of people in the market have been buying second homes and taking advantage of great rates. With demand lower than on other areas on the peninsula, the market may slow down there. The condo market has been weaker than the general housing market and that is likely to continue to soften, especially outside of San Francisco. This Spring, we are likely to see more homes on the market, and inventory may tick upward for a couple of reasons. One reason is that some sellers may think we’re at the top of the market and decide to sell for fear of losing equity. Another reason is that refinance rates are increasing as well, making it much more expensive to borrow against a home’s equity. It remains a great time to sell, especially for people in need of extra cash or looking to move out of state. The impact of rate increases elsewhere in the country may turn those areas into buyer’s markets, especially for buyers in a strong cash position. For buyers looking to get in the market, I think it is critical to move quickly right now before rates and appreciation price you out of the market completely. If you’re waiting for the market to soften, in my opinion, you’re making a bad bet that will cost you lots of money as rates continue to increase and home values appreciate. Rates still remain relatively low from a long-term perspective and figure to get considerably higher.
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