I received this email today:
“I have a question for your two cents –
I figure Vancouver has a 20% + decline in it, but I can’t see any reason for the decline until mortgage rates rise.
As long as home owners can pay the bills, they will stay where they are.
Granted a slowdown in housing will hurt the economy in general, (and a strong loonie won’t help either), but if supply doesn’t increase, prices won’t come down.
Unless the bond junkies get jumpy, I don’t see mortgage rates rising for many years.
I can’t see the bond market getting worried about the USA because where else are they going to go?
If the bond investors lose confidence in the USA then we will be on an apocalyptic cliff, and the house price will be the least of your worries.
However, as you know, sentiment can push markets anywhere, and if home owners get worried about the value of their homes, they will will provide a self fulfilling prophecy.
So after a long winded message, my question is this.
What is going to cause house prices to come down in the short term (6-18 months)?
It won’t be mortgage rates.”
Great question! I think it nicely captures one of the very valid questions that people have about the ‘supposed’ real estate correction to come. The line of thinking is sound in that home prices do traditionally have an inverse correlation with interest rates. Most will recall that real estate corrections in the past have often been the nasty side effect of a rate tightening at the Bank of Canada.
The relationship traditionally holds. But why hasn’t it in the US? Why have historically low interest rates failed to revive a dead housing market. In the US, you can borrow money for your mortgage on a 30 year TERM for less than 4%. That means you will never pay more than 4% for the entire duration of your mortgage, unlike in Canada where we are exposed to interest rate risk every 5 or so years. So what gives?
Before I answer that, I would also like to remind my faithful readers that affordability is not the primary motivation in foreclosures, as the emailer suggested. Negative equity is the real killer. I addressed this in an article I posted several months ago. Perhaps I should make it one of the primers since there does seem to be some misunderstanding on this point. From that article:
“Interestingly, the report pointed out that a large number of homeowners who had their mortgage payments reduced to levels that the government deemed “affordable” still defaulted, noting that “negative equity is the most important predictor of default” (pg17).”
I would never suggest that our coming experience with foreclosures will mirror that of the US, but I do think it will be much higher than people believe.
At any rate, back to the initial email. Here is my response:
Certainly a material rise in mortgage rates would be detrimental to the housing market, but I share your view that rising interest rates are likely not in the cards, and that is precisely what should have you worried. Ask yourself why record low interest rates have failed to revive the US market, the market in Spain, Italy, Ireland, the UK (granted it rebounded nicely but has faltered lately), not to mention the housing market in Japan, which is still well over half of its former peak 20 years later. The issue is peak credit in a society. House prices will fall under the weight of deflationary forces exerted by the
twin factors of falling demand for credit and increased savings.
The problem with bubbles is that they are inherently unstable. They are built upon erroneous consumer psychology and an unsustainable expansion in credit. It’s not hard to see these two factors at work: Record high home-ownership rate, record high percentage of bulls, a wide-spread acceptance of the idiom that ‘houses never fall in value’, record consumer debt, record low savings, record expansion in home equity lines of credit, and an aging population now past its peak demand for housing.
A mean reversal in these factors spells deflation. Now I’m not suggesting that our experience will mirror that of the US, but we’ve got our own issues to deal with.
Again as to your question, tell me this: What sparked the initial decline in US home prices in the Fall of 2005? Sales disappeared and inventory started to build for seemingly no reason. Why? The subprime fiasco was not on the radar yet and would play out in the subsequent years. The foreclosure issue really only gained steam once negative equity hit home and teaser rates reset higher.
So what sparked the initial downturn? It was that demand had been satiated in previous years through the loosening of credit requirements (sound familiar?) and a society-wide credit binge (again, sound familiar?). This had the net effect of pulling demand forward, leaving a gap that eventually had to be dealt with. Once that gap hit and sales and prices started to fall modestly, even the potential buyers decided to sit on the sidelines for fear of catching a falling knife.
That’s the problem with mass psychology; it’s a fickle lover. It provides the fuel for the fire of real estate appreciation on the way up, but can seemingly disappear on a whim. Now let’s connect that to our home-grown experience. We’re heading for the second worst October sales in the past decade, eclipsed to the downside only by the credit crisis induced panic of 2008. Why is that? I believe we are seeing the markets turn. Demand has largely been met and has been pulled forward. How many people who would otherwise have been considering buying a home today were instead lured by the drastic emergency interest rate cuts 2008-2009? Granted inventory is not building at an alarming rate, but
we’ll see how that plays out in the Spring. If demand for credit falls (and it has to), expect deflationary forces to wreak havoc in leveraged assets, particularly real estate.
I think we’ll see the first year-over-year declines in many markets reported in October…November at the latest. I think we will be -5% to -10% down by the New Year. You can’t have falling demand, increasing supply, and stable prices for long.