* You’ll learn why a rising Fed Funds rate doesn’t necessarily mean rising mortgage rates.
* The main determinants of buying a home.
* Where we are in the property market cycle.
* You can always refinance. You can never change the purchase price of your home.
* Mortgage rates and the 10-year yield have spiked higher in 2018 due to inflationary pressures from higher wage growth, strong economic indicators, and strong corporate earnings growth.
Now that the Fed is raising interest rates (4X in 2018, a couple more in 2019), you are hearing everybody from real estate brokers to market pundits in the media say, “Buy now before it’s too late!” There’s nothing like a little Fear Of Missing Out to get people to make big decisions without thoroughly thinking things through.
The instant response everybody should have when fed this line is: Don’t higher interest rates make homes less affordable at the margin? If homes are less affordable, doesn’t that hurt property demand? And if demand for property declines, doesn’t that mean prices might go down instead?
Whenever you are talking to someone whose main source of income is through transactions, be a little suspicious. After all, from a real estate broker’s point of view, it’s always a good time to buy or sell!
This post aims to explain how to think about a home purchase (or sale) in a rising interest rate environment. We’ve already discovered how to invest and potentially profit in the stock market when rates rise.
My hope is that this post educates future homebuyers, reduces the number of future debt welchers, and creates a stronger America as a result!
UNDERSTANDING THE FED FUNDS RATE
The Federal Reserve controls the Federal Funds rate, the interest rate everybody is referring to when discussing rising rates. The Federal Funds rate is the interest rate in which banks lend to each other, not to you or me. There’s generally a minimum reserve requirement ratio a bank must keep with the Federal Reserve or in the vaults of their bank, e.g. 10% of all deposits must be held in reserves. Banks need a minimum amount in reserves to operate, much like how we need a minimum amount in our checking accounts to pay our bills. At the same time, banks are looking to profit by lending out as much money as possible at a spread.
If a bank has a surplus over their minimum reserve requirement ratio, they can lend money at the effective Federal Funds rate to other banks with a deficit and vice versa. You can see how an effective Fed Funds rate of only 0.15% would induce a lot more inter-bank borrowing in order to re-lend to consumers and businesses, and keep the economy liquid. This is exactly what the Federal Reserve hoped for once they started lowering interest rates in September 2007 as home prices began to collapse.
Study the charts below.
By the summer of 2008, everybody was freaking out because Bear Sterns was sold for a pittance to JP Morgan Chase. And then on September 15, 2008, Lehman Brothers filed for bankruptcy. Nobody expected the government to let Lehman go under, and that’s when the panic really began.
What happens when everybody freaks out? Banks stop lending and people stop borrowing! This is called “a crisis of confidence.” The Federal Reserve lowered the Federal Funds rate in order to compel banks to keep funds flowing. Think of the Federal Reserve as keeping the oil flowing through a dying car engine.
It’s been almost seven years since the Federal Reserve lowered the Fed Funds rate to 0.15%, and since January 2009 the stock market is up more than 220%; the housing market has recovered with some markets like San Francisco blowing past its 2007 peak by 30%, and unemployment has dropped to 4.1% in 2018 from a high of 9.9% in March 2010. What does this all mean?
The Federal Reserve’s main goals are to keep inflation under control while keeping the unemployment rate as close to the natural rate of employment (full employment) as possible. The Federal Reserve does this through monetary policy – raising and lowering interest rates, printing money, or buying bonds. They’ve done a commendable job since the financial crisis, but inflationary pressure is an inevitability.
Why is inflation bad? Inflation isn’t bad if it runs at a foreseeable 1-3% annual clip. It’s when inflation starts going at 5%, 10%, 50%, 100% where things get out of control because you might not make enough to afford future goods, or your savings and investments are losing purchasing power at too fast a pace, or you simply can’t plan your financial future.
The only people who like inflation are those who own real assets that inflate along with inflation. Remember to always try and convert funny money into real assets! Everybody else is a price taker who gets squeezed by higher rents, higher tuition, higher food, higher transportation and so forth.
The Federal Reserve needs to raise interest rates before inflation gets out of control. By the time inflation is smacking us in the face, it will be too late for the Fed to be effective since there’s a lag in monetary policy efficacy. Higher interest rates slow down the demand to borrow money, which in turns slows down the pace of production, job growth and investing. The rate of inflation will eventually decline as a result.
If the Federal Reserve could engineer a 2% inflation figure and a 5% unemployment figure forever, they’d take it!
FED FUNDS AND BORROWING RATES FOR YOU AND ME
The Federal Reserve determines the Fed Funds rate. The MARKET determines the 10-year yield. And most importantly, the 10-year Treasury yield is the predominant factor in determining mortgage rates. There is definitely a correlation between the short duration Fed Funds rate, and the longer duration 10-year yield as you can see in the chart below.
Study this chart very carefully, as it will tell you a lot about whether you should buy or sell a home in a rising interest rate environment.
The first thing you’ll notice is that the Fed Funds rate (red) and the 10-year Treasury yield (blue) have been declining for the past 30+ years. There have definitely been times where both rates have spiked higher between 2% – 4% within a five-year window. However, the strong trend is down due to knowledge, productivity, coordination, and technology.
What else can we learn from this chart?
1) The Fed probably won’t raise the Fed Funds rate by more than 4%, or even come close to a 4% increase. From 1987 – 1988, the Fed raised rates from 6% to 10%. From 1994 to 1996, the Fed raised rates from 3% to 6%. From 2004 to 2007, the Fed raised rates from 1.5% to 5%.
2) The longest interest rate upcycle is about three years once the Fed starts raising rates. We now know that 4% and three years are the backstop for a rising interest rate environment.
3) The 10-year yield doesn’t fall or rise by as much as the Fed Funds rate. In other words, you probably don’t have to fear a large interest rate reset if your ARM mortgage expires. In fact, anybody taking an ARM mortgage over the past 30 years has seen their interest rates fall. Owning a 30-year fixed mortgage is a more expensive route.
4) The S&P 500 has generally moved up and to the right since its beginning. The steepening ascent corresponds to the drop in both interest rates since the 1980s. The S&P 500 can be a representation of housing prices across the country.
5) The current difference (spread) between the Fed Funds rate and the 10-year yield has been over 2% for the past seven years, which provides a significant buffer for the Fed to raise Fed Funds while the 10 Year Treasury yield can still stay the same.
Take a look at what happened between 2004 and 2010. The spread between the 10-year yield and Fed Funds rate was around 2%, just like it is now. The Fed then raised the Fed Funds rate to 5% from 1.5% until they burst the housing bubble that they helped create! The Fed Funds rate and the 10-year yield reached parity at 5%, instead of the 10-year yield maintaining its 2% spread and rising to 7%.
IMPORTANT POINT: the Fed can raise the Fed Funds rate, and the 10-year yield may not even budge higher given the spread is currently 1.35%+ (~2.85% – 1.5%). In other words, mortgage rates might not move up much at all after the Fed finishes raising rates over the next three years.
Below is a closeup chart of the S&P 500, the Fed Funds rate, and the 10-year bond yield.
THE MARKET KNOWS BEST
Now that you’ve got a great understanding of interest rates, you can see how vacuous a statement it is when someone tells you to buy property before interest rates go up. If anybody says this to you, they are either ignorant or do NOT have your best interest at heart.
The Fed Funds rate could easily go back to 2% over the next three years. Meanwhile, the 10-year yield might very well stay at the current 2.5% range, or it may at most maintain a 2% spread and rise to 4% during the same period. Remember, the markets determine the 10-year bond yield, and we’ve so far just discussed domestic demand.
China, India, Japan, Europe are all huge buyers of US government bonds as well. Let’s say China, Japan, Brazil, Switzerland, and Greece all go through hard landing scenarios. International investors will sell Chinese, Japanese, Brazilian, Swiss, and Greek assets/currency, and BUY US government bonds for safety. The USD is, after all, the world currency. If this happens, Treasury bond values go UP, while bond yields go down.
The US has foreigners hooked on our debt because US consumers are hooked on international goods, most notably from China. The more the US buys from China, the more US dollars China needs to recycle back into US Treasury bonds. China certainly doesn’t want interest rates to rise in the US. If they do, their massive Treasury bond position will take a hit, and US consumers will spend less on Chinese products at the margin!
Thank goodness we’re all in this together!
THE MAIN DETERMINANTS OF BUYING A HOME
Rising interest rates are generally a result of a robust economy. A robust economy is by far the most important determinant of housing prices. If the unemployment level is declining, people in your city are getting raises, and expectations for continued growth are there, housing prices will continue to go up, despite rising rates. The issue the Fed has is getting the TIMING of their monetary policy right to contain inflation and engender maximum employment.
I recommend everybody be at least neutral the property market by owning their primary residence. Being neutral the property market means you are no longer a victim of inflation given your costs are mostly fixed. You can’t really profit from the real estate market, unless you sell your house and downsize. You don’t really lose either, so long as you can afford the house, since you’ve got to live somewhere.
Before going neutral the property market, it’s important to have the confidence that you’ll own your house for at least five years, if not at least 10 years. I never go into a property purchase thinking I’ll sell within 10 years. In fact, I always have the mindset that I plan to buy and own forever since I buy property for lifestyle purposes first.
The only way you can gain confidence of owning your property for 10 or more years is if:
* You’re bullish about your employer’s growth prospects
* You’re bullish about your own career growth and talents
* You’ve got 30% or more of the value of your property saved up in cash or liquid securities (e.g. 20% down, 10% buffer at least)
* You love the area and can see yourself living there forever
* You’ve got rich parents, relatives, or a trust fund to bail you out
If you’re taking out a PMI mortgage because you’ve got less than 20% down, it’s understandable why you’d be scared buying property. You can’t afford it! In the old days, most people would simply pay all cash!
PROPERTY MARKET FORECAST
Property is local, so it’s hard to say what your market will do. I believe property prices will still go up, but moderate closer to the rate of inflation between 2016-2019. I don’t believe property prices will go down nationwide, especially since rates will stay relatively low, and Hillary will come in and do everything possible not to mess up the bull market.
That said, historians will notice a seven year cycle of ups and downs in the real estate market. If we consider Jan 2011 as year one, we’re closer to the END of a bull run instead of the beginning. In other words, don’t be in such a hurry to buy! I personally sold my rental house in mid-2017 for $2.74M that I bought in 2005 for $1.52M to simplify life and take advantage of high valuations (sold for 30X annual gross rent).
I reinvested $500,000 of my $1.8M in proceeds in real estate crowdfunding. Valuations are much cheaper in the heartland of America (~10X annual gross rent vs 20 – 30X annual gross rent in coastal cities) and net rental yields are also much higher as well (8% – 15% vs. 2% – 4% in coastal cities). If I can earn a 12% return on my crowdfunding investment, I will equal my cash flow from my $2.74M house that I sold with $2.24M less in exposure.
If you want to buy property when prices are at all-time highs in 2018, then buy property to live in and enjoy life. I wouldn’t be leveraging up and buying expensive coastal city real estate for investment purposes. The only area I’m comfortable buying is in middle America. There’s no need for people to be clustered in the most expensive parts of America anymore thanks to technology.
Explore real estate crowdfunding: If you’re looking to buy property as an investment or reinvest your house sale proceeds, take a look at Fundrise, one of the largest real estate crowdfunding platforms today. They allow everyone to invest in mid-market commercial real estate deals across the country that were once only available to institutions or super high net worth individuals. They are the pioneers of eREIT funds and they are creating an Opportunity Fund to take advantage of tax-efficient Opportunity Zones. Thanks to technology, it’s now much easier to take advantage of lower valuation, higher net rental yield properties across America.
Shop around for a mortgage: Check the latest mortgage rates online through LendingTree. They’ve got one of the largest networks of lenders that compete for your business. Your goal should be to get as many written offers as possible and then use the offers as leverage to get the lowest interest rate possible. This is exactly what I did to lock in a 2.375% 5/1 ARM for my latest refinance. For those looking to purchase property, the same thing is in order. If you’ve found a good deal, can afford the payments, and plan to own the property for 10+ years, I’d get neutral inflation and take advantage of the low rates.
Updated for 2019 and beyond. Rates are going up due to strength in employment, wages, and corporate earnings.