What Does a 39 Percent Drop in Refinancing Mean?
Unfortunately, nobody knows exactly what the magic number is that will tip the scales and drastically alter the real estate market
Rates for 30-year mortgages bottomed out around 3.4 percent in July 2016. Rates recently broke through the 5 percent-mark and the 10-year treasury just hit a seven-year high. At the same time, Wells Fargo announced the layoffs of more than 600 mortgage workers and many other banks have followed suit. What is the market telling us?
WHY ARE RATES RISING?
Thirty-year mortgage rates follow closely with longer term treasuries (10-year). The Federal Reserve has increased short-term overnight rates at a faster pace than the market anticipated. This has caused longer term yields to rise as well. The increase in longer term yields led to the recent jump in mortgage rates.
The Federal Reserve's job is to help, not only fight inflation, but smooth out economic cycles. Currently, inflation has been nonexistent, as wages have flattened. The Fed is instead focusing on smoothing out the economic cycle. It appears rising rates are meant to ensure it has room to drop rates when the next economic cycle hits, which most economists are saying is around 2020.
Wages are basically stuck, with little upward movement for workers. As wage growth has been tepid, any increase in rates can't be absorbed. If workers aren't making more, how are they going to pay higher mortgages? At some point, the math stops working.
IS 5 PERCENT THE LUCKY NUMBER?
Historically, a 5 percent mortgage is still a great rate, but the market has grown accustomed to lower rates during the last eight years. Now is the first time in that same stretch that rates have cross the 5 percent threshold. The prior low rates have allowed people to afford more than they could in the past. The recent increase in rates will have a profound impact on purchases, refinancing and the commercial market. This leads us to the question: Is 5 percent the tipping point in real estate?
IS DENVER A HARBINGER ON PURCHASES?
In Denver, sales of homes work $1 million or more fell 44.4 percent between August and September, and sales of homes more than $500,000 dropped 33 percent in the same period. Overall, sales this September are down 21.4 percent year-over-year. This is due, in large part, to the increase in mortgage rates.
Denver, like many pricey markets, will feel the effects quicker than others as the media home price rises. As a result, the average loan size is also bigger, so each move in rates will impact borrowers more. Denver's recent slow down in purchases will eventually hit other, less expensive markets as rates continue to rise.
Not only are sales slowing because of rates, refinancing activity is down considerably. In the past, consumers used a refinance to lower their monthly payments or pull cash out. This has all but dried up.
Refinance volume, which is highly rate-sensitive, fell 6 percent for the week and was 39 percent lower than a year ago. "As mortgage rates increased to a five-week high, the refinance index decreased to its lowest level since the end of 2000," said Joel Kan, MBA's associate vice president of economic and industry forecasting.
Not only are commercial property interest rates also rising, but commercial property values are feeling the raise in rates. Interest rates and capitalization rates typically move in lockstep. So, higher rates mean higher capitalization rates. In 2016, the 10-year treasury was 1.4 percent, the current cap rate is 3.2 percent. For example, if a property traded on a 3 cap in 2016 when rates were at their lowest, with the newest move in treasury rates, that new cap rate would be closer to 4.8 percent. The value of the property will be substantially reduced; fortunately in a rising economy, rents are also increasing, but not fast enough to compensate for the quick rise in rates.
Remember, capitalization rates and values move in inverse, so the higher the cap rate, the lower the value. This has huge implications on commercial real estate values.
WHAT DOES THIS MEAN FOR THE MARKET?
Rates above 5 percent have exceeded every major prediction for 2018. The consensus going into this year was that rates would be around 4.5 percent. This steep run-up in rates has caused a knee jerk reaction from the market. Based on the steep fall in purchase transactions above certain price points, the noticeable drop in refinancing and the impacts on commercial properties, is crossing the 5 percent threshold telling us something more about the economy?
Although it appears 5 percent is a limit for the real estate market that has had profound impacts, it doesn't appear that 5 percent is a trigger for a market crash.
The market is starting to adjust to the higher rates, which has led to the slowdown in purchase and refinance transactions. As the markets adjust to the new norm, it is expected there will be a cooling of purchase and refinance activity, but I don't see this as an indicator that the real estate market will tank.
WHAT IS ON THE HORIZON?
How mortgage rates (and treasuries) rise in the future is the $1 million question.
Currently, the 10-year treasury rate is around 3.2 percent. Several economists have predicted the 10-year treasury will go above 4 percent in 2019. If they are correct, this would put mortgage rates north of 6 percent. Could that be the magic number for the real estate market?
Unfortunately, nobody knows exactly what the magic number is that will tip the scales and drastically alter the real estate market.
My bet is that a 6 percent rate could be the tipping point.