Fed Meets Today: Will Raising Rates Mess With Housing?

Shoot Date: 
Tuesday, April 28, 2015

For sure. But probably not in the manner you're thinking.

When it comes to housing, most of us assume that rising interest rates translate to softening demand and valuations. But this time that won't be the case. In fact, the exact opposite will play out. Rising rates will cause inventory to decline even further, driving values up. That's good news for investors, but not so good for average folks already grappling with housing affordability.

That’s because the same indicators the Fed's watching to time tapering and rate increases also mirror consumer confidence and housing demand. So, at least in theory, everyone's singing off the same song sheet. Moreover, the Fed has made it abundantly clear that rate increases will be slow and incremental. Consequently, we're not seeing home buyers rushing in to beat the rates. And years of pent up demand continues "penting-up."

Notwithstanding the temporary psychological impact we see when rates exceed 4%, 5% and so on, we know that the majority of home buyers ultimately focus more on the amount of their monthly mortgage payment than their actual interest rate.

Of course, higher interest rates mean higher mortgage payments and lower purchasing power, but there are always strategies to mitigate that. For example, buying down the interest rate (typically seen more frequently as a seller-offered incentive when rates rise), using a larger down payment, or (gasp) buying a less expensive home.

Then there's the fact that, unlike jewelry for example, which we can simply delay buying when the price of gold rises, we all need a place to live. The alternative to buying a home is renting one. But here's the rub, rental rates have been rising far faster than interest rates will. Not to mention the other components that typically tip the scale for folks calculating their rent verse own equation, and will still prevail, regardless of interest rate increases of the ilk we're expecting.

We know demand will organically increase by around 1%, or 1.5 million buyers, per year for the next ten years. In addition, aging and obsolete units will need to be replaced.

Yet inventory, which began declining in 2011, remains stubbornly low at 4.5 months supply verses a more healthy 6 months. So what's ailing inventory?

For starters, hundreds of thousands of units were converted by investors, the likes of Blackstone's Invitation Homes, into scattered residential rentals. When the bubble burst, single family home construction ground to a halt.

Since then, builders, attracted to higher returns and lower risk, have focused on higher priced homes and multifamily construction. Millions are still underwater and unable to sell. And homeowners in general are staying put almost twice as long as they used to. In particular, millions of Baby Boomers are electing the "age in place" rather than sell their homes.

Rather than temper demand, rising rates will reduce supply even further. That's because we know that, as rates rise, folks hesitate to sell their homes, as doing so means giving up those low rate mortgages. Great for the home improvement industry. Not so much so for housing inventory, which began declining in 2011 and has remained stubbornly low ever since.

These dynamics underscore the importance of tax policy that will keep U.S housing trades flowing in the coming year, notwithstanding rising interest rates.

For example, the capital gains exclusion allows folks to sell a primary residence and retain $250,000 for single filers and $500,000 for married filers, tax free. Certainly, the capital gains exclusion is one policy Congress will want to retain, perhaps even increasing the caps, which date back to 1997 and have never been indexed for inflation, in order to increases inventory from the top down. After all, before a move up seller will consider listing his home, he needs to be confident that he will be able to find another one to move up into.

Extending the Mortgage Forgiveness Debt Relief Act is another example of tax policy that will help improve housing supply as rates rise. The Act, first passed in 2007, allows folks who are underwater to sell their homes without having to pay income tax on the mortgage debt their bank forgives. The Act expired December 31. But with millions of homeowners still underwater and inventory already is such short supply, is still clearly needed.

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