A Housing Bubble?
Though we have witnessed a period of rapidly increasing housing prices, similar increases in price have occurred in the recent past without resulting in a major drop. Additionally, the housing market has historically demonstrated the ability to withstand a sharp increase in interest rates without sustaining a major correction in housing prices.
Still, given that most American households retain the bulk of their wealth in their homes, even the possibility of a housing bubble is a cause for concern. An additional factor that concerns many experts is the prevalence of adjustable rate mortgages and its potential effect on the stability of the housing market in the event that interest rates rise.
Let’s start with a look at prices. The chart below shows median home prices from 1968 to the present day (1968 is the year the National Association of Realtors began tracking housing prices). Despite several corrective cycles in the U.S. stock markets during this period, housing prices have, overall, increased steadily. The few downward adjustments have been small relative to the steady increases in the home prices.
For instance, from November 1972 through November 1982, home prices increased 250% from $28,800 to $100,800. Subsequently the home prices suffered one of the worst periods between 1982 and 1983, when prices fell from $100,800 (November 1982) to $90,900 (September 1983). This translates to a 9.8% price decline, and prices did not recover to 1982 highs until May 1986. Another decline in housing prices occurred from April 1991 through February 1993 when prices declined 8.7% (from $140,600 to $128,400), and prices did not recover to the highs until June 1994.
Median Home Prices 1968-Present (Seasonally Adjusted)
source National Association of Realtors (NAR) Western Sates
What about interest rates? Many who argue that a housing bubble currently exists cite that an extended period of historically low interest rates has artificially escalated prices, and so a rise in interest rates will cause a fall in prices. There is little doubt that the period of falling and historically low interest rates since the mid-1990s has helped to increase prices. But the assertion that higher interest rates will lead to a downward trend in housing prices is incorrect. In fact, history tells the opposite story.
10 Year Bond Yields (1968-Present)
Consider the period between April 1977 and September 1981, when interest rates (10 year U.S. Treasury Bond Yields) increased from 7.2% and touched as high as 15.8%. During this same period real estate prices increased from a median value of $58,100 to $95,500, a 64% increase.
A possible explanation is that real estate generally fares well in periods of high or rising inflation. A period of rising interest rates typically coincides with rising inflation, which would tend to increase housing prices. When inflation is present, household incomes tend to rise, as do the costs of construction, labor and other inputs, all of which would tend to increase prices.
Many real estate investors and homeowners seem to be complacent about the likelihood of a rise in interest rates. Even if rates rise 1-2%, they believe they will still be better off with an adjustable rate loan. To explain why they should be more concerned, let me point out the historic correlation between the interest rate and crude oil prices. See the chart below, which compares interest rates with crude oil prices over time (oil prices are adjusted for inflation).
Crude Oil (adjusted for inflation) vs 10 Year Bond Yields
Source Norman’s Historical Data – NYMEX light crude oil cash prices
While the recent increases in oil prices from the low $20s per barrel in 2002 to $50 per barrel (the recent closing price at the time of this writing) do not seem to have affected interest rates, as you can see this is an exception to the rule. Historically, most increases in crude oil prices coincide with higher interest rates. This is why the prospect of interest rates rising (and by more than 1-2%) in the coming years is very likely.
What is concerning about the prospect of rising interest rates? Before the mid 1990s, home mortgages were typically 30-year fixed rate programs, which ensure existing homeowners that payments on their home do not increase as interest rates rise. With an adjustable rate mortgage, the homeowner’s payments are adjusted to reflect the current market interest rate, so if interest rates escalate, so do the homeowner’s payments. The prevalence of adjustable rate mortgages represents significant risk to the housing market overall and especially to individual households.
Recent history characterizes the housing market to be resilient. Even tough economic times have not resulted in major downward corrections. Additionally, the housing market has shown an ability to withstand increases in interest rates and actually make gains during these periods. So whether a housing bubble is forming is yet to be determined. For individual households, the concern now must be the possibility of rising interest rates. Failure to prepare for them could strain those who have taken the fiscally aggressive option of adjustable rate mortgages,
Disclaimer - This article should not be deemed to be legal or investment advice, merely an educational discussion of the behavior the housing market in the past.
About the author - Brian W. Topley, CCIM is a real estate investment advisor and offers Real Estate Investment Services through Arroyo & Coates, Inc. and TIC 1031 Investment Property through OMNI Brokerage, Inc.
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