Is The Value Of Your Home Going To Fall As Rates Rise? 2
Another way to observe that home prices (in the US, and most likely everywhere else) don’t react in the same mechanical way to changes in interest rates as bonds do, is by looking at their correlation.
Bonds and rates have an inverse relationship. This means a correlation of -1. When one variable goes up, the other goes down.
If this were true for houses and rates, we would see a correlation that, at the very least, remains negative most of the time.
Instead we have this:
The correlation between home prices and 30y mortgage rates continuously cycles between 1 and -1. In other words, the relationship between both constantly changes, as is the case with most other market relationships in a free, capitalistic environment.
Simply put, homes aren’t 30y bonds.
Why is this the case?
The first reason is that the home and bond parallel is one of those comparisons that make a lot of sense of the surface, but doesn’t actually hold up to scrutiny.
Yes, folks do take out 30y mortgages to purchase homes, and if a homeowner rents out her property, the rent could be seen as a coupon payment.
From this perspective it really does seem like homes are, or at least, can mimic the properties of a 30y bond.
But, homes and bonds are fundamentally different.
Bonds pay a fixed coupon, and a fixed repayment of principal (the amount that the bond issuer borrowed) at maturity. The coupon isn’t that important to our discussion since the bulk of a bond’s value comes from the repayment of principal.
This big lump sum repayment that happens in the future is discounted to the present using prevailing interest rates.
For those unfamiliar with this concept, it is simply a time value of money calculation, and is also used in discounted cash flow models to value companies.
As such, higher rates mean lower present values, since the principal amount is discounted by a larger percentage rate.
Mathematically, if the numerator is always fixed (the principal), increasing the value of the denominator (interest rates) will necessarily give us a smaller result. Hence the mechanical and inverse relationship between a bond’s price and interest rates.
However, while bonds repay a fixed principal amount, houses do not.
For the sake of easy comparison, let’s assume a homeowner sells her house after 30 years.
In all likelihood, the amount she gets for it won’t be close to the amount she paid for it, as the price at that point will be determined by supply and demand for homes in that particular location.
If she sells her home when the real estate market is very bullish, the price she gets for it will be higher than what she borrowed to pay for it.
Again from a mathematical perspective, if the numerator is higher, and the denominator is also higher, what will the result be?
It would depend on whether the numerator increased by more than the denominator, or vice versa.
Which means that the relationship between interest rates and home prices isn’t as tight and mechanical as they are with bonds.
But won’t higher rates still mean a lower price for her home today, because she isn’t selling it yet?
Not necessarily.
To be continued…
Do You Want To Make Money Trading?
Learn how to, and more, in our Trading Courses.
