2016: Back To The Future?

We have seen a remarkable rise in net worth over the last several years recognized by increased portfolios and property values. Since January 2010, the S&P 500 has nearly doubled, the DJIA is up over 70%, and many local communities’ home values have increased over 60%. Our valley has experienced a remarkable transformation from the valley of silicon and chips to mobile technology and cloud computing. Heavy investor funding: from venture capital to private and conventional money, has fueled our innovation hubs and our portfolios. This bullish market is largely thanks to our friends at the Federal Reserve. The federal funds rate has remained at almost zero during this period (2010 – current), fueling international borrowing and investing and enabling aggressive investing. To sum it up, money has been practically free to borrow – and that tap is about the slow down.

It is all but a certainty that the Federal Reserve will begin raising its key interest rate starting this December. Analysts are already anticipating this move and markets are starting to adjust respectively. Foreign to us for nearly a decade now, we must re-learn how to navigate this world of rising interest rates.

Snapshot

2015 has been a good year to be a Seller. The idea of putting a sign in front of your home and instantly getting an offer was somewhat true, but the delta on what a Seller could sell if the home was prepared and marketed properly was huge (which is always the case). In 2015, I have seen larger down payments from Buyers (either from cashing out of stocks or money from a previous sale) than previous years and I’ve seen their continued fear of a market that seems to be unstoppable. I’ve communicated to my Sellers and Buyers that the feeling of invincibility is not sustainable and market exhaustion does kick in, either forcibly through a market correction or emotionally through typical quarterly cycles.

The current market is moving like clockwork as it does each year: The fall and winter bring lower available inventory and a shift in motivation. Will this continue downward or is it just another holiday quarter? That is the question that no one can answer with certainty. However, the methodical shift in interest rates should catch everyone’s attention; it doesn’t matter if you are a cash buyer or a 10% down buyer – a higher interest rate environment will not only impact your checking account, but also your competition. Nevertheless, Seller expectations will remain high; they saw the spring and early summer sales and will expect similar prices. If they don’t get their price, they are either raising the asking price or pulling off the market waiting until spring, hoping the market improves. It is possible this strategy can backfire on the Sellers this time.

A Comparison

Let’s look at the real estate cycles in the early 90’s, the “dot.com” days and the Great Recession: three cycles experienced right here in the valley. In each cycle, price adjustments occurred, but were never the same.

The savings and loan crisis in the late 1980’s and into the 90’s, along with the first Gulf War, were a few of the key factors playing into that market cycle. The Fed did adjust interest rates with quite large swings: from an average 9.21 in 1989 to 3.02 in 1993 and 4.21 in 1994. I remember many manufacturing and government jobs being absorbed. That era included a huge number of military base closures with many in California.

The dot.com days, well, let’s just say that Pets.com, Webvan and many other chronic money-losers finally came to an end when investors realized the lack of a business plan was problematic. I remember kids driving Ferraris and smart people arguing how companies don’t need to make money to be viable.

That leads us to the Great Recession, where the collapse in the financial market spiraled into a global affair. We experienced more foreclosures than I recall from previous cycles and the Fed brought the interest rate to near zero where we have since stayed for nearly ten years.

Because there are inevitably differences in market cycles, it is important to constantly be looking at data in multiple ways: I personally look at the raw aggregate data provided from all sale transactions and hypothesize market conditions with daily sentiment from Buyers and Sellers, as well as real estate trends I’m witnessing real time. I felt it timely to provide a comparison of the 3rd quarter in 2007 vs. today. I chose this point in time because it was the lowest affordability since before 1991. I think this shows a good picture of how the market has changed at a point of time that we still remember. In 2007 businesses were booming, money was flowing and everyone seemed happy…until the financial market started collapsing. I remember Buyers were working hard to get their down payment together and struggling in many cases to get their offer accepted with stiff competition. Apple and Google stocks were doing well, albeit nothing like today. Jobs were good, John Chambers was at the helm for Cisco and home ownership was a stretch for many to afford.

I think the data speaks for itself: yes, we are in a euphoric time where money falls from trees and companies are valued a billion times over, but to what end? Interest rates are approximately 2.58% cheaper today than the peak in 2007 and home values are up 30-80% from peak to peak. Can you image the difference to your monthly payment if interest rates were 6.38% at the current home values? Many real estate professionals and economists argue our market will go to the moon without hesitation. I am dumbfounded by these statements when I look at the cost of money and how I think that will be a significant variable to our market as the interest rates rise. Sure a quarter or half percent raise will force the tightening of belts, but it is the 1-2% change that will really make the market squirm.

My Forecast

Even though the Fed has stated the interest rate adjustments will be slow, the effect on the market may be more impactful. I am already seeing major institutional lenders tighten their guidelines in anticipation and rates have begun to rise, albeit minimally. The National Association of Realtors Economist, Lawrence Yun, forecasts the average 30 year rate to increase 1% by the end of 2016. That’s a 25% increase to your monthly expense of interest – I’d say that is significant.

Even though inflation seems low, I believe it is skewed by the low cost of oil, which is a big piece of the inflation figure. Year over year, crude oil is down over 36%, but the largest adjustment was from August 2014 at $97.86 and it has been dropping practically ever since down to around $40 per barrel. That’s a significant drop in just over a year and the data should be catching up with it soon, so crude oil will be less of an impact on inflation starting in 2016. What does this mean to most of us? We will save money at the gas pump, but our grocery bills won’t come down. The higher home values and rental rates, which have continually driven down affordability, will become more apparent once the macro data supports this information instead of these inflationary costs being anecdotal stories.   Prepare yourself for a higher interest rate environment.

What should you do in 2016?

Buyers: As the rates go higher it will put pressure on your monthly mortgage amount. If prices continue to rise come spring you may have to lower your price point to cover the additional costs. If prices soften due to increased rates, it may net the same monthly expense to you. I suggest you stay the course and we can continue the conversation. We don’t know the correlation between interest rate to home price, but since you likely are looking for a longer term play, we want to find you the right property, not just any property.

Sellers: Cheap money is your friend – it means more money in your pocket because of high borrowing power. At a certain point prices should be impacted from higher rates and you won’t see any benefit from higher interest rates (except maybe your bank savings rate). Consider a strategy that fits your situation and plan ahead – preparation will be even more important in 2016 and I am available to help prepare a sound and smart strategy for you.

suzanne sarto