The Federal reserve dropped the federal funds rate again which wasn’t a big surprise as the market was pricing in a 96% probability of a rate cut. This is the third cut this year effectively creating a “floor” under real estate. How did the federal reserve create a floor? How long will the floor hold up? Are there upside and downside risks?
First, it is important to note that the federal reserve does not directly control mortgage rates. The fed controls the “federal funds rate”. The federal funds rate is the rate at which banks and credit unions lend reserve balances to other banks and credit unions overnight. In a nutshell this is the rate banks get on the money they are holding in cash/reserves. Here is a more detailed explanation from Wikipedia . To illustrate that the federal reserve doesn’t directly control rates, even though rates were dropped last week by the federal reserve, interest rates (10 year yield) actually increased since the rate announcement.
So how are mortgage rates set? Unfortunately, mortgage rates are not “set”. There is no government or private party that can set rates per se. Mortgage rates are typically based on the 10 year treasury yield which is set by market expectations of future growth/inflation or lack thereof. For example if we are in an expanding economy rates will typically increase as prospects for inflation/growth are high. The inverse happens in a slowing economy like we are in now.
How did the Federal Reserve create a “floor” under real estate?
By dropping interest rates, the federal reserve has made mortgages on commercial and residential properties cheaper (i.e. interest rates have dropped) which has led to real estate becoming “effectively cheaper”. The reason I say “effectively cheaper” is that the price of real estate in most markets is flat this year, but actual payments made to buy the real estate enables buyers to spend more for the same dollars.
For example, assume a buyer was purchasing a $400,000 house on a 30 year mortgage with 20% down which is a loan of 320,000. The payment for the house assuming a 4.9% rate (this is when rates peaked last November) this would be a payment of $1,698 per month. Now as the federal reserve has dropped rates, the 30 year mortgage is closer to 3.5%, using the same example as above, the new payment would be 1436.94. Because of the lower payments a buyer can afford a more expensive house or buy the same house with a smaller payment. Furthermore, with the lower rates many renters might move to buyers as the mortgage payment is at or less than a rent payment.
With payments dropping substantially a “floor” has been created meaning real estate values have remained stable. The value of homes in most markets have remained relatively stable as the federal reserve has cut the federal funds rates and mortgage rates have dropped substantially which has increased consumers buying power spurring demand for real estate.
How long will the real estate “floor” hold up?
With rates remaining low into the foreseeable future, real estate will continue to be a desired asset to own. Unfortunately, low rates alone can’t sustain the real estate market. Currently consumer confidence and spending seem to be holding up well which combined with lower rates. This should sustain the real estate market for another 6-12 months at the current pace. Looking further out is the million dollar question. As soon as we start seeing consumer confidence pullback, real estate values will also pull back a little. There is considerable uncertainty when this will occur.
What are the upside and downside risks?
- Upside: Soft landing
- The Federal Reserve has cut rates three times this year to try and minimize downside risks to the economy. They have been very proactive in their approach as the economy continues to do well. The goal of this policy is to try and orchestrate a “soft landing” where a little “air” is let out of the economy but we don’t enter a full blown recession, merely a slowing of growth. This is a difficult feat to pull off but the federal reserve might be able to engineer a soft landing as they have been proactive on cutting rates early as we get later into the economic cycle. Under this scenario real estate would remain flat to a slight decline, but nothing like the last recession.
- Downside: Hard landing
- There is also a possible downside to the federal reserve current policy where rates were eased at this point in the cycle. The federal reserve has already cut three times this year which limits the amount of “ammunition” they have left if the economy takes a serious downturn. The current federal funds rate now is around 1.5% which is already at a historically low level. This does not leave much room for further cuts and the market will likely not respond much as the rate is already so low. This increases the risk for a “hard landing” where the economy falls into a recession. Even with a hard landing in the economy I don’t foresee a repeat of 7/8 this would likely be a milder recession with property values decling 10-20% in most markets.
Summary
The federal reserve has created a floor under real estate as a result of the three recent interest rate cuts. Currently the floor seems to be holding up well in most markets, but the weight on the floor is getting heavier. The million-dollar question is how long the real estate floor will/can last and what happens as a result. Will we have a gentle “soft landing” or will there be an economic thump, a hard landing? Stay tuned as we are going to find out in the next 12-18 months.
Additional Reading
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Written by Glen Weinberg, COO/ VP Fairview Commercial Lending. Glen has been published as an expert in hard money lending, real estate valuation, financing, and various other real estate topics in the Colorado Real Estate Journal, the CO Biz Magazine, The Denver Post, The Scotsman mortgage broker guide, Mortgage Professional America and various other national publications.
Fairview is a hard money lender specializing in private money loans / non-bank real estate loans in Georgia, Colorado, Illinois, and Florida. They are recognized in the industry as the leader in hard money lending with no upfront fees or any other games. Learn more about Hard Money Lending through our free Hard Money Guide. To get started on a loan all they need is their simple one page application (no upfront fees or other games).