Deficits Matter
by Jim Scott

It appears the interest rate party is drawing to a close. This has implications for those either owning property or looking to buy or sell. Not all of this is necessarily bad news; there are strategies you can employ to weather or profit from the inevitable changes to the housing market. Opportunity is the bedfellow of change.

The bottom of the current interest rate cycle occurred in June. As fixed rate home loans flirted with four percent, the three-year old boom in purchasing and refinancing real estate spurred the housing market. Ten-year treasuries, which for the most part determine 30-year fixed rate loans, yielded 3.11% last summer. By this writing, the rate moves between 4.5 and 4.25 percent, bringing mortgage rates in tow. This happened for two reasons; capital is moving from the bond market (which depresses bond prices and that in turn increases interest rates) into the stock market, and second, the Government needs to borrow 87 billion to finance the war in Iraq and to pay for tax cuts. Every borrowed dollar pushes up mortgage rates. And the Feds are going to be major borrowers over the next several years.

The advocates of deficit spending, or rather those who believe it can be beneficial in the short run, are refugees from either the Reagan-era school of supply-side economics or the Roosevelt Keynesians. In a nutshell, they believe Federal borrowing (or tax cuts) will generate economic growth and eventually government revenues thereby ending the need to borrow money. This can be true, but the housing market is always the fall guy in this scenario, at least in the medium run. No one can argue that higher rates surely will follow current fiscal and foreign policy decisions. But just because the bar is closing doesn't mean you need to leave the party.

The Rate Change in Action

The effect of change in the interest rate cycle is apparent in the market today. Prices are still appreciating but the rate of increase is slowing. In fact, the rate of appreciation has declined for three straight months and that trend should continue.

An analysis of the upper-end market in the 92103 zip code shows the effect of higher interest rates on prices. There have been sixty sales that closed between May 1, 2002, and October 27th, 2003, for homes selling for more than $900,000. Thirty-eight sales between May 2002 and May of 2003 show an adjusted price of about $377 per square foot. The eleven homes that closed between May 2003 and August of 2003, the peak of the market in this cycle, sold for $467 per square foot. Those purchase contracts, using an average of a 60 day escrow, were written between March and June, or the absolute bottom of the interest rate cycle.

The eleven closings from August to the present, reflecting higher interest rates in effect since June, have been $446 per square foot, or a drop of 5% in three months. It is clear from this particular slice of the market that these rates have started to be built into the pricing structure. The year-over-year increase in this market segment was a respectable eighteen percent prior to the bump in rates. The subsequent five percent decrease in prices for more expensive homes may be a harbinger of things to come. In the short run, prices in this market segment should reflect the large market trends-little or no meaningful appreciation during 2004.

A Time To Buy

In spite of this, buyers should not be afraid to move into this marketplace. Rates are still very low historically and home prices, when adjusted for inflation, are not much higher than the last market peak in 1990. Looking forward, the price of land and the regulatory process virtually insure high housing prices. There is no magic here; we have collectively decided to make San Diego a very expensive place to live. I see no political will to change the formula and therefore prices have nothing but upside. Traffic, urban migration and fires are all adding an additional layer of demand for Metro housings. There is probably no smarter place to be.

Rents, on the other hand, are more problematic. For better or worse, working class jobs have been under siege in the era of globalization. The working poor has been one of our major growth industries over the past decade. Because of this I would be very careful when purchasing any residential income property.

Some Ideas

First, it is not too late to refinance to either lower your rate or move from a variable rate loan into a fixed-rate loan. Loan markets are either fixed-rate markets or variable markets. There is no question we have been in a fixed rate market for the past year; when this new cycle peaks then variables should be the preferred option.

Second, if you own investment property, fixed rate is generally not a great option. The only play I could recommend is move your existing variable rate loan from one of the more volatile indexes into a loan based on the 11th District Cost of Funds Index. This move will save you money over the next three years. The 11th District index will move very slowly, even if short-term rates spike over the next year or two. The index is determined mainly by rates paid to depositors; those of you making killer one percent returns at your local bank know this rate will stay low for the next two years.

Election year politics and the Middle East are the jokers in the pack. The former may mean relatively easy money in 2004. The latter is open ended.