Inflation and Home Prices

Inflation is the overall upward trend in the cost of goods and services. Over time, as those costs increase, the value of a dollar falls because the consumer cannot purchase as much with that dollar as in the past. Inflation is officially measured by the Consumer Price Index and the Producer Price Index, but it’s as easily understood by the cost of a gallon of gas today, versus a year ago.

According to Christopher Cagen of First American Real Estate Solutions, in the bigger picture, real estate prices in the long term have historically outpaced inflation by 2 to 3% per year. He goes on to say that there are three primary reasons: first, our population is growing; second, there is a limited amount of land; and third, the economy is growing. The bottom line? If you can afford to hold on to property for the long-term, real estate is an excellent hedge against inflation.

In the short-term, there are two factors that dictate property values: supply and demand and interest rates. When the demand for housing exceeds the available supply, prices rise. When the supply of property exceeds the demand, values fall. Similarly, when interest rates climb, buyers can purchase “less house” for the same payment. This means that fewer people can afford to buy a median-price home, therefore there are fewer buyers in the market. This generally results in a higher demand for rental properties, and as a result, an increase in rental rates (the supply/demand rule in action).

Loan Defaults and Foreclosures

As short term interest rates go up, we may see a slow down in the real estate market and ultimately in housing prices until wages increase to offset the interest rate increases. Every time the Federal Reserve raises short term interest rates by .25%, approximately one million less people can buy a home.

As Cagan states in the his white paper, Mortgage Payment Reset, the Rumor and the Reality, the people most likely at risk to foreclosure due to their Adjustable Rate Mortgages (ARMs) resetting are those borrowers in 2004 and 2005 that obtained loans with teaser interest rates in the 1.0 – 2.5% range. Approximately 21.5% of these borrowers have negative equity, meaning the amount of their loan is greater than the value of their home. As their ARMs adjust to higher interest rates, the new payments can be up to double their initial payments in some cases. Those homeowners that cannot afford the new higher payments will most likely face foreclosure as they will not be able sell their home due to their negative equity position.

Cagan adds that the effect of foreclosures may not have a significant impact on the economy as the defaults will likely occur over several years and many of the borrowers may be able to modify their loans. However, those foreclosures may cause short-term softening in real estate prices as more properties come on the market.

What’s Next?

None of these economic indicators—higher interest rates, an increase in foreclosures, and an increase in housing supply—suggests that “the bubble will burst.” Rather, it looks like the housing market is in for a soft landing, not a crash, with prices stabilizing assuming there is not a major downturn employment like Aerospace industry in the early 1990’s.

In areas where record year-over-year price increases of 25% have been the rule, this stabilization may well feel like the end of an era, but the market is cyclical. As price increases come back to earth, with more modest single-digit annual appreciation of a few percent, homeowners with fixed-rate mortgages will be able to await the next upturn.

In today’s market, you may be better to rent if your intentions are to sell in next several years. The transaction costs of a sale (generally 5 - 7%) may be greater than any gain from the sale of your property.

If you are a homeowner with an ARM, and have a payment adjustment coming up, it may be a good time to switch over to a fixed rate loan to lock in your interest rate. However, if you plan to sell your home within the next two years, you will probably be better off keeping your existing loan due, as the fees for refinancing may exceed your projected savings.