Broker Check

Lower Interest Rates May Once Again Destabilize the Real Estate Market

November 20, 2019

The Federal Reserve reversed course this year by lowering their short-term interest rate target three times from 2.25% a year ago to a target of between 1.50% to 1.75% currently. The Fed has described its recent policy as “insurance cuts.” In other words, the Fed is lowering interest rates preemptively in an attempt to reduce the risk of a future recession rather than in response to recessionary pressures. While this may seem like a benign policy strategy, low interest rates are often sited after the fact as a major contributor to market bubbles. We may once again be seeing signs of this in the real estate market.

Many metropolitan areas have complained about real estate shortages. Meanwhile, new housing starts have remained at moderate levels throughout the current cycles as home builders remain more cautious than they were during the last cycle. The recent decrease in interest rates has helped to stoke home construction activity with new home permits up 8% year-over-year. However, it takes time to build new homes so the supply shortage is unlikely to be alleviated anytime soon. This has caused the increased demand for real estate which was stoked by lower interest rates to spread to other areas of the real estate market.

According to real estate site Redfin, the median home price in the US increased 5.4% in October, the highest month-over-month increase since 2012. The sharp increase was due to an increase in demand from lower interest rates combined with a decrease in supply as the number of listing decreased in the month. The largest price increases have been focused on more affordable homes where it has become a strong seller’s market (more buyers than there are sellers). This combination of low interest rates and restricted housing supply in many metro areas resembles the hosing market from 2004 to 2006 when housing prices increased sharply.

The increase in home values is not the only parallel between the housing boom in the early 2000s and the current market. Refinance activity has also increased with a large percentage of the refinancing activity being cash-out refinances. At the peak in 2006, 89% of all mortgage refinances involved the borrower cashing out equity which increased consumer spending power and kept the economy growing. Following the financial crisis mortgage refinancing activity fell sharply. In addition, very few of the mortgages that were refinanced were a cash-out refinance. However, that has changed. The number of cash-out refinances has increased sharply since its low in 2012 with the rate of increase accelerating in recent years. In 2018, 81% of mortgage refinances involved the borrower cashing out equity. In other words, homeowners are once again taking advantage of low interest rates and using their homes as ATMs to fund spending in other areas. Should this trend continue the imbalances that led to the financial crisis could once again become a problem despite tighter lending standards and increased regulation.

Warren Buffett famously said: “The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.” There is little that an individual can do to stop others from destabilizing the real estate market by cashing out equity to fund consumer spending. However, people can protect themselves  by avoiding such risky behavior and focusing on building a strong financial foundation by reducing debt and spending responsibly. This does not mean that refinancing a mortgage is a bad idea. In fact, it may be an attractive option given the current low interest rates. However, it is prudent to avoid cash-out refinancing unless it is a part of a well thought out financial plan in which all of the risks to such a strategy have been considered.