This article discusses the cyclical pattern of rises and falls of interest rates, and makes the case for a future of real estate pricing characterized by ascending mortgage rates.
Bond market cycles
The average monthly 10-Year Treasury Note (T-Note) yield since 1900 is shown on the chart above. As demonstrated, interest rates on the 10-Year T-Note have shown a slow but steady overall decline since 1980, following a rise from lows last reached in 1941.
We can now see that 1940-1950 marked the beginning of what has become a 60 year rates cycle: approximately 30 years of rising rates, followed by 30 years of falling rates. This roughly mirrors the 60-year period prior to1950, in which interest rates peaked in 1921.
Going forward for the next roughly 60 years, first tuesday expects another slow upward run in rates for 20-30 years, and then a reversal into rate declines as occurred following 1980.
The interest rate on the10-Year T-Note dropped as low as 1.47% in early June 2012 as the euro, the renminbi, and the Brazilian real all weakened against the U.S. dollar. These lows are extreme and are evidence of international monetary stress.
But with global economic chaos, highlighted in Europe, China, India and Brazil, the non-responsive U.S. jobs market, and the flight of cash into U.S. dollar-denominated liquid assets (bonds), we have likely not seen the lowest point in the trough of this long-term interest rate cycle. This cycle’s bottom for 10-year T-note rate, which has declined since 1980, is yet to be found. Since mortgage rates have historically moved in tandem with the 10-year T-note at a 1.4% spread, it is likely that home loans will also remain cheap for the immediate future.
As first tuesday has previously reported, current real interest rates on 10 year T-Notes are at or near their zero bound. They cannot fall further unless the Fed goes negative, which it will not do without severe cause. As a measure of financial security returns to the market in upcoming years, rates at some point will start to rise, and mortgage rates will begin running up at the same time.
Furthermore, the upcoming period of rising rates is likely to last for quite a long time – two or three decades.
The last three cycles in bond market rates have been extremely regular, points out Chris Watling of Longview Economics. A 29-year downtrend in rates (1920-1949), followed by a 32-year uptrend (1949-1982) and another 31-year downtrend lasting to the present. While the regularity of this pattern of 30-year passages should be considered coincidental (they very easily might have been forty years, or twenty), precedent establishes that bond market rate changes are much slower and more gradual than, say, changes in the stock market.
Interest rates and asset pricing
In previous interest rate cycles, rates rose for approximately thirty years, peaking in 1927 and again in 1979 after rising from essentially zero in the late 1940s, following the recovery from the Great Depression.
In 1947, at the end of World War II, interest rates on the 10-year T-Note were near zero, much as they are today. Then, from 1947 to1979, rates moved steadily upward.
1947 is a key year for other reasons as well: it marked the end of a recession, and a long-awaited return to prosperity after the Great Depression of the late-1930s. If this interest rate pattern holds true, as first tuesday believes it will, we now find ourselves at the beginning of a reversal in the real estate market comparable in type, if not in intensity, to the turnaround after 1947.
During the resulting half cycle of rising interest rates from 1947 to 1979, the wealth of investors increased even as interest rates rose, housing construction was very strong and employment and prosperity increased as well. The American Dream of jobs, cars and homes for all was in full bloom during this period. We expect to experience similar conditions during the two or three decades, into the mid 2030s – once we get out of this Lesser Depression (this time, hopefully without the stimulus of a war effort).
For the housing market, however, rising interest rates, even static interest rates, mean that there will be no short-term profits to be had from any increase in pricing. The notorious “Greenspan Put,” which we have grown accustomed to seeing after every drop in interest rates, will not and cannot be repeated to artificially generate profits in any asset market – commodities, stocks, bonds or real estate.
Mortgage rates are inextricably tied to bond market rates, and every increase in bond and mortgage rates means a decrease in a homebuyer’s purchasing power – the amount he can borrow based on repayment at 31% of income – and an increase in the earnings of the rentier class. Thus, a buyer will experience a decrease in the amount he can pay for a home.
Less money borrowed by homebuyers means less price received by sellers for their properties. Of course, this annual decrease in purchasing power is fully offset in actual (nominal) dollar terms by the Fed’s monetary policy, which maintains annual inflation around 2%. This inflation is the driving force increasing wages from year to year.
As in the period of rising bond and mortgage rates from 1949-1980, prices will be held down, rising only in response to consumer inflation as permitted by the Fed and any “price appreciation” at the property’s location (appreciation occurs solely due to demographics, as demand for real estate within an area increases with a rise in the area’s population density or an increase in the income of that population beyond the rate of inflation). [For more in price evaluation, see the first tuesday Income Property Brokerage (IPB) suite of forms]
The Economist: The cycle turns
Interest rates in the modern day
Today the economy remains mired in what some economists have termed a Lesser Depression: a period of ongoing joblessness, debt deleveraging, increased savings and low income that in many ways exhibits the symptoms of an actual depression. This period has not paralleled the several garden-variety recessions of the past 60 years. To combat the lack of available money, the Fed has all but exhausted its strongest tool: the ability to lend endlessly at ever lower rates.
For the first time in sixty years, interest rates have once again reached zero. 10-year T-Note rates have remained near 2% since late-2011: an interest rate that should be considered approximately equivalent to a zero real rate since a sustained actual rate of lower than 2% will be too low to cover the standard 2% rate of core inflation which annually lowers the purchasing power of the dollar invested in the bonds.
In spite of government guarantees, home mortgages are a riskier investment than treasury bonds. Mortgage rates are thus typically priced at a 1.4% margin over the rate on 10-year T-Notes. Under this historical margin, mortgage rates should currently be at around 3 %, not the 3.7% to 4.1% range they have occupied for the past nine months.
The fact that mortgages cannot drop further than the rate on 10 year T-Notes plus 1.4% suggests that mortgage rates are now essentially at zero. They will not drop lower unless the Fed “goes negative,” naming paying private banks to lend to the public. In such a hypothetical “negative rate” scenario, the Fed would go so far to stimulate lending as to accept repayment at a rate lower than zero (i.e., lend one dollar to be repaid at 97 cents, a negative interest rate of 3% per annum). Going negative will be necessary only if dramatic further stresses are imposed on the jobs in this economy.
The next three decades
When bond yields hit their bottom in the late 1940s, they remained low for a period of eight years. While bond yields have now reached a low in actual rates, and hence a long-term peak in homebuyer purchasing power, it is likely that we will have until 2015 before rates begin to rise gradually.
When rates rise, agents will quickly learn to cope with an unfamiliar set of investment and pricing challenges (including different income multiplier/capitalization rates, long-term holding periods before profits can be taken, and Due-On Sale clause assumptions).
The key lesson to remember in those upcoming years will be that real estate is most properly priced and held for its inherent rental value. Those who buy property for speculative gain, not rental income, will see as little success in gains from a flip as those who invested in the real estate market from 1950 to 1980, when mortgage rates moved slowly, steadily upward until they exceeded 18%.
The next peak in rates, whether or not they reach past heights, will likely take another 30 years to arrive. But this cycle’s days of steadily decreasing interest rates, accompanied by steadily falling rents, producing ever increasing prices and profits (and §1031 hysteria) have run their course to the bitter end.
In the last two decades, it was possible to purchase a parcel of real estate, vacant or improved, and tale a profit, much greater than the rate of consumer inflation, merely by holding that parcel for a short period of time. This is no longer an option. Prices may rise in narrowly defined locations enjoying a population density explosion, but most will be dampened by constantly rising interest rates which will keep prices from rising faster than the rate of core inflation.
The negative pricing effects of increasing interest rates can be at least in part counterbalanced by improved zoning. If property prices rise beyond the rate of inflation, local governments will have to permit density to increase to accommodate those who are attracted to the area or suffer the consequences of an asset inflation bubble. Smart investors will look to purchase property in urban centers which have already begun to establish themselves as the most desirable abodes for the next generation of homeowners and tenants.
In the long run, investors in real estate will need to increase their wealth, not by flipping their properties for profit, but by generating rental income over the course of long-term ownership. Income property will be bought to be operated and managed for an annual net operating income, capitalizing at the rate proper going forward.
In boom times, property owners were accustomed to capitalization rates (cap rates) of 6% or less. For upcoming years, 10% may be more normal. Prudent property selection, careful research, forward looking capitalization rates and a long-term commitment to real estate ownership will be the keys to success in the new paradigm.